2. that are assumed to explain stock returns: 1. Departures of GNP growth from e
ID: 2798460 • Letter: 2
Question
2. that are assumed to explain stock returns: 1. Departures of GNP growth from expectations (Factor 1): beta 1.5 2. Unanticipated inflation (Factor 2): beta - 0.9 3. Market factor (Factor 3): beta 1.2 The expected returns on the three factors are 12% (Factor 1), 8% (Factor 2) and 15% (Factor 3). Assume the risk-free return is 6%. i Calculate the risk premiums on the three factors. (3 %) i. According to the Arbitrage Pricing Theory (APT), what is the (4 %) iii. If you expect the return on Fringe Products Ltd to be 25%, is this a (3 %) expected return on Fringe Products Ltd? good buy? Explain the reasoning behind your choice. b) You are given the following statement: When considering an international investment it is important to take into account the market size, trading volume and concentration of the underlying stock market Do you agree or disagree with the statement? Note: Your answer should elaborate on the statement with reference to an ideal market structure and should be supported by examples. (231S %) TOTAL 33% %Explanation / Answer
2a-i.) BetaGNP=1.50; Expected Return =12%
BetaInflation= 0.90; Expected Return =8%
BetaMarket= 1.20; Expected Return=15%
Risk-Premium for GNP = (ER-Rf)/BetaGNP= (12-6)/1.50 =4.00%
Risk-Premium for Inflation = (ER-Rf)/BetaInflation= (8-6)/0.90 =2.22%
Risk-Premium for Market = (ER-Rf)/BetaMarket= (15-6)/1.20 =7.50%
2a-ii.) As per APT, expected return,
ER =Rf + BetaGNPxRPGNP + BetaMarketxRPMarket + BetaInflationxRPInflation
= 6 + 1.50x4.00 + 0.90x2.22 + 1.20x7.50
= 6.00 + 6.00 + 2.00 + 9.00
= 23.00%
2a-iii.) The expected returns of 25% is more than the value of expected returns calculated above. Since, the returns are lower, it is not a good buy.
2b.) Yes, it is true that when considering an international investment, it is important to take into account the market size, trading volume and concentration of the underlying stock market. This is because if the company is not traded on important exchanges in the country of interest, or it is not possessing good liquidity, it will become really difficult to take an exit from such investment. Moreover, the counters which are traded in good numbers on national exchanges helps in true price discovery and it leads to confidence in the investors that they are not taking up rather expensive buy. As one might not be truly aware about the international conditions, true price discovery will help in mitigating that risk to some extent. All the data related to company's history will be available in the public domain and it can thus be referrred before taking any investment.
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