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Question 6 (2pt) Consider the following multifactor (APT) model of security returns for a particular stock. Factor Factor Beta Factor Risk Premium Inflation 1 .

Question 6 (2pt)

Consider the following multifactor (APT) model of security returns for a particular stock.

Factor

Factor Beta

Factor Risk Premium

Inflation

1.2

6%

Industrial production

0.5

8%

Oil prices

0.3

3%

1. If T-bills currently offer a 6% yield, find the expected rate of return on this stock if the market views the stock as fairly priced. [1pt]

2. In APT, we assume a factor to asset returns:

Rs = E(Rs) + 1F1 + 2F2 + 3F3 + s

which implies that

E(Rs) = Rf + 1RP(F1) + 2RP(F1) + 3RP(F1).

Here, F1, F2 and F3 are surprises to macro factors. Thus, APT can predict the expected return of stock s, and also predict the how the realization of the return Rs due to surprises in macro factors F1, F2 and F3.

Suppose that the market expects the values for the three macro factors given in column 1 below, but that the actual values turn out as given in column 2. Calculate the revised expectations for the rate of return on the stock once the surprises become known. [1pt]

Factor

Expected Value

Actual Value

Inflation

5%

4%

Industrial production

3%

6%

Oil prices

2%

0%

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