Suppose that investors believe that the following three factors affect the expec

Question

Suppose that investors believe that the following three factors affect the expected return to stocks: the stock market's average excess return, which is f_1 = 7%; the price of oil, which increases on average by f_2 = 4.0%; and the average interest spread between 10-year Treasury bonds and 3-month Treasury bills, which equals f_3 = 1.8%. Suppose that the average risk-free interest rate is 3.00%. Use arbitrage-pricing theory (APT) to compute the expected returns to the following stocks using the beta coefficients for each stock shown in the following table.

Explanation / Answer

APT is an alternative to capital asset pricing model (CAPM).

The APT formula is :

E(r) = Rf + (B1*RP1) +(B2*RP2) + (B3*RP3) + .........(BnRPn)

Where:

E(r) =Expected rate of return

Rf = Risk free rate of return

B = The sensitivity of asset return to a particular factor

RP = Risk premium associated with a particular factor.

Therefore in the given case,calculations of expected return is as follows:

PietreDure Electric = 3 + (1.5*7) + (1*4) + (0.3*1.8) = 18.04%

Graffiti Analytic = 3 + (1*7) + (1.5*4) + ((0.5)*1.8) = 15.1%

Fantasy Corporation = 3 + (3*7) + (1*4) + ((1.0)*1.8) = 26.2%

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