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    Risk premium; no-arbitrage return;stock of over-under priced

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    Consider the C. Stock A has an expected return of 16.4%, a beta of 1.4 on factor 1 and a beta of 0.8 on factor 2. Stock B has an expected return of 15%, a beta of 0.9 on factor 1 and a beta of 1.2 on factor 2.
    The risk premium on the factor 1 portfolio is 3%. The risk-free rate of return is 6%.

    a) What is the risk-premium on factor 2 if stock A is correctly priced?
    b) What the no-arbitrage return for stock B should be?
    c) Is stock B over- or under-priced? Explain (in a short sentence)
    d) According to APT can arbitrage opportunity for B persist for long time? Explain (in a short sentence)

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    Solution Preview

    a) RA = Rf+Beta for factor 1 for stock A*risk premium for factor 1+Beta for factor 2 for stock A*risk premium for factor 2
    16.4%=6%+1.4*3%+0.8*risk premium for factor 2
    0.8*risk premium for ...

    Solution Summary

    This post shows how to calculate the risk-premium, no-arbitrage return for stock and discusses about the stock of over or under-priced and arbitrage opportunity