1. Suppose 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) 3
Consumer confidence ( C) 5
The return on a particular stock is generated according to the following equation:
R = 10% + 1.5 I + 0.6 R + .70 C + e
Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 5%.
Is the stock over- or under-priced? Explain.
Equilibrium return = Risk free rate + 1.5 I + 0.6 R + .70 C
Equilibrium return = 5% + 1.5 ...
The solution explains how to calculate the equilibrium rate of return using APT.