Problem 2 (20 marks)

You are exploring the use of APT in making investment choices. You have identified three factors labelled F₁, F₂, and F₃ with corresponding risk premia RP₁ = 5%, RP₂ = 3%, and RP₃ = 3%.

A stock with ticker ABC has historically shown returns which have followed the equation:

r_ABC=0.13+1.0F₁+.90F₂+1.5F₃+e_ABC

• What is the equilibrium rate of return for stock ABC using the APT, if the T-bill rate is 3%?
• If the price of stock ABC is $45, do you conclude that it is underpriced or overvalued? Explain your reasoning fully.
• If the expected price next year will be $53, what is the fair price today, that is, the stock price now that will not allow for arbitrage profits?
• Assume that the T-bill rate decreases to 1%, with the other variables remaining unchanged. Would you recommend to buy or sell stock ABC?