Consider a three-factor APT model. The factors and associated risk premiums are
Factor | Risk Premium |
Change in GNP | 5% |
Change in energy prices | – 1 |
Change in long-term interest rates | +2 |
Calculate expected rates of return on the following stocks. The risk-free interest rate is 7%.
a. A stock whose return is uncorrelated with all three factors.
b. A stock with average exposure to each factor (i.e., with b = 1 for each).
c. A pure-play energy stock with high exposure to the energy factor (b = 2) but zero exposure to the other two factors.
d. An aluminum company stock with average sensitivity to changes in interest rates and GNP, but negative exposure of b = –1.5 to the energy factor. (The aluminum company is energy-intensive and suffers when energy prices rise.)
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