Question
1. You work for an investment firm which has been using a regression model, loosely based on Ross APT, to estimate future returns of stocks
1.
You work for an investment firm which has been using a regression model, loosely based on Ross APT, to estimate future returns of stocks in the American retail sector. Their regression model is:
E(Ri) = rf + B1 Elite + B2 Emp + B3 SSalest-1 + B4 (Elite)*(SSalest-1)
Where i indexes the stock of interest, rf is the risk-free rate (in percent), Emp measures employment rate in the US (in percent), SSalest-1 is the lagged sales level (in billion USD) of the studied retail sector from the preceding period and Elite is a dummy variable which takes the value of 1 if the firm serves only high-end markets and high wealth clientele (LA, New York, Boston, Chicago, etc) and is zero elsewise.
The historical F-test p-value of the model has been 0.12 and the historical out-of-sample adjusted R2 has been 0.105.
You have been given a table of estimated parameters for two stocks your firm is currently considering for investment.
Firm | B1 | B2 | B3 | B4 |
Factor | 2 | 0.1 | -0.01 | 0.015 |
Factor p-value | 0.07 | 0.09 | 0.07 | 0.45 |
A) Assuming the risk-free rate is 1%/year and the expected Employment rate is 70%, and this period retail sales was 55 billion USD estimate the return using the firm model for Ballmart (not Elite) and Biffanys (Elite).
B) A popular business TV show host, Tim Rainer, says he thinks Ballmart will earn 8% this year while he expects Biffanys to earn 10%. If you believe your firms model how should you trade against individuals that follow Tims advice?
C)Referring the statistical measures of the firms model, critique the model. Next, interpret the sign on the third factor and describe in words what it would mean given that it relates to last period sales.
D)Your boss has some insights that he thinks Biffanys is going to change their business model so they are no longer Elite. Interpreting the fourth risk factor and knowing that last periods sales were very high he thinks theyll put off entry for at least one more period. Argue why your boss thinks the way he does and then, referring to p-values, argue why hes probably wrong to believe this.
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