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(b) You have been assigned the task of estimating the expected returns for three different stocks: X, Y and Z using the Arbitrage Pricing Theory
(b) You have been assigned the task of estimating the expected returns for three different stocks: X, Y and Z using the Arbitrage Pricing Theory (APT). Based on your research you have formed an opinion that the historical risk premiums associated with the three risk factors, but you are unsure of what these risk factors represent. These values are Afactor 1 = 4%, Factor 2 = -0.3%, and factor 3 = 2.5%. You have also estimated the following factor betas for all the three stocks with respect to each of these potential risk factors. The table below provides details of individual factors and the loadings (factor betas) associated with the three factors with respect to stocks A, B and C. Stock Afactor 1 A B 1.30 0.80 1.05 lFactor 2 0 0.70 0 Afactor 3 0.37 0.40 0.35 (i) Calculate the expected returns for the three stocks using Factor 1. Assume a risk free rate of 5%. (4 marks) (ii) Calculate the expected returns for the three stocks using all of the three risk factors and assume the same 5% risk free rate. (4 marks) (iii) What type of exposure might Factor 2 imply? Given the estimated factor betas, is it reasonable to consider it a systematic risk factor? Explain your reasoning
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