Consider an economy where two factors are sufficient to describe the returns on common stocks. Stated formally,

we have: E(ri) = rf + bi1?1 + bi2?2

The following table gives the estimated sensitivities of stocks A and B to the two factors, as well as their expected returns.

Stock bi1 bi2 E(ri)

A 0.7 1.4 12.7%

B 2.1 0.7 17.6%

The risk-free rate of return is 5%.

a) Suppose A and B are priced consistently with the two-factor APT above. Calculate the risk premiums of the two factors (?1 and ?2).

b) A stock C is currently priced at $20, and its expected price in the next period depends on the state of the economy as follows:

State Recession Normal Boom

Probability 0.2 0.7 0.1

PC $17 $22 $25

The stock C pays no dividend. Cs estimated factor sensitivities are bC1 = 0.3 and bC2 = 0.8. Is the stock C overvalued, undervalued, or correctly priced?