Question

Question 9

You want to use the following asset pricing models to determine the expected return on McDonald’s stock.

• CAPM: β_M = 0.48
• FF3 factor: β_M = 0.40, β_SMB = -0.41, β_HML = 0.54

The info. of the risk-free rate and the risk factors are as follows:

• The risk-free interest rate is 3%.
• E(R_M) = 9.5%, E(R_SMB) = 2.5%, E(R_HML) = 6%

The expected return on McDonald’s stock based on the FF3 factor model is 7.815%

Following Question 9 –

Based on the FF3 factor model, what is its alpha? ______%

Answer 1

As per Fama and French Three Factor Model:

Re= Rf+[E(RM)-Rf] xβM+ [E(RSMB)-Rf]×βSMB+ (E(RHML)-Rf) xβHML

Given: E(RM) = 9.5%, E(RSMB) = 2.5%, E(RHML) = 6% , βM = 0.40, βSMB = -0.41, βHML = 0.54

Where Re= required rate of return
Rf= risk-free rate

Re= 3+[9.5-3] x0.40+ [2.5-4]×-0.41+ (6-3) x0.54
Re = 7.425%

The Expected rate of return on the stock= 7.815%
Alpha = expected rate of return- Required rate of return= 7.815%-7.425% = 0.39%

Alpha is equal to 0.39 %.