Question

model is appropriate. The cross-sectional relationship Assume a two-factor API between expect return and factor loadings indicates the price of factor 1 is 0.15 and the price of factor 2 is-02. Furthermore, you have estimated factor loadings for stock s X and Y as follows: Asset biib2 X 1.4 0.4 Y0.90.2 and the expected return on an asset having zero loading on both factors is 0.05. According to the APT, what are the approximate equilibrium returns of each of the two stockS

Answer 1

Stock X

Rf   = 0.05

Price of factor1 (RP1) = 0.15

Price of factor 2 (RP2) = -0.2

Be1 = 1.4

Be2 = 0.4

E(ri) = Rf+Be1*RP1+Be2*RP2

            0.05+(1.4*0.15)+(0.4*-0.2)

E(ri) = 0.18 or 18%

Stock Y

Rf   = 0.05

Price of factor1 (RP1) = 0.15

Price of factor 2 (RP2) = -0.2

Be1 = 0.9

Be2 = 0.2

E(ri) = Rf+Be1*RP1+Be2*RP2

            0.05+(0.9*0.15)+(0.2*-0.2)

E(ri) = 0.145 or 14.5%