Question

Suppose that the market can be described by the following three sources of systematic risk with associated risk premiums.

Factor	Risk Premium
Industrial production (I)	7	%
Interest rates (R)	4	%
Consumer confidence (C)	5	%

The return on a particular stock is generated according to the following equation:

r = 12% + 1.2I + 0.8R + 1.00C + e

a-1. Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 8%. (Do not round intermediate calculations. Round your answer to 1 decimal place.)

a-2. Is the stock over- or underpriced?

Answer 1

Given,

Factor	Risk Premium
Industrial production (I)	7	%
Interest rates (R)	4	%
Consumer confidence (C)	5	%

T-bill rate = 8%

Solution :-

a-1- Equilibrium rate of retuon using APT - T-billsate +(1.2 x I) +(0.8 x R) +(1.00 x S) - 8% +(1.2 x 72.) +(0.8 x 44.) + (1.00 x 57.) - 8% + 8.4 % + 3.2%. + 5% - 24.6% where, I , R & C represents disk premium of various factors. a-2 According to the equation for the return on the stock, the actually expected return on the stock is 12% (the expected surprises on all factors ade zero by definition). Since the actually expected return based on disk is less than the equilibrium deturn, the stock is Overpriced.