Consider the Fama-French (1993) three-factor model:

r_it--r_ft =a_i + B_im (R_mt--r_ft) + B_isSMB_t+ B_ihHML_t +E_it

where R_mt, SMB_t, and HM_t are the market, book-market, and size factors, respectively. To analyze one stock, you run the above regression on the three factors and obtain a_i =1%, B_im=0.9, B_is=0.3, and B_ih=0.2.

Assume that the market beta is the same if you get from either the CAPM or the three-factor regression.(In practice, the values are close.)

Suppose that the risk-free interest rate is 3%. and that the market, book market, and size premiums are are 12%, 5%, and 6%, respectively.

a. What is the required rate of return on the stock if you believe the CAPM to an accurate descriptor?

b. What would your answer be if you believed the three-factor model were a more nearly accurate descriptor?

c. What would your answer be if you do not believe factor models are valid?