1) According to a recent regression result, you find that GM stock has a market
ID: 2792525 • Letter: 1
Question
1) According to a recent regression result, you find that GM stock has a market beta of 1.6, size beta of 0.3 and value beta of 0.75. Use Fama-French 3 factor model to find the expected return for GM stock. (assuming 7% market risk premium, 3% riskfree rate, 2% return premium for small-cap stocks (ie., size risk premium), and 1.5% return premium for value stocks (i.e., value stock premium)) Three-Factor Model Identify macroeconomic factors that could affect stock returns Estimate expected risk premium on each factor (rfactorl - rf, etc.) Measure sensitivity of each stock to factors (b1, b2, etc.)Explanation / Answer
Using Fama-French model,
Expected Returns, E(R) = Rf + b1 x RP1 + b2 x RP2 + b3 x RP3
where, Rf - risk-free rate = 3%, b1 - Market beta = 1.6, b2 - Size beta = 03 and b3 - Value beta = 0.75, RP1 - Market Risk Premium = 7%, Size Risk Premium = 2%, Value Risk Premium = 1.5%
=> E(R) = 3% + 1.6 x 7% + 0.3 x 2% + 0.75 x 1.5% = 15.925%
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