Suppose the following version of the APT is a good model of risk in the stock market. There are three factors: (1) the stock market's excess return, in percentage points; (2) the unemployment rate minus its natural rate (the level the unemployment rate would be if the economy were at full employment), in percentage points; and (3) the real federal funds rate minus its long-run equilibrium value. Suppose the natural rate of unemployment is 4.5 percent and the long-run equilibrium value of the real federal funds rate is 3.0 percent. Each of the following stocks has the beta coefficients shown in the table below:
?1i
?2i
?3i
Royal Dutch Shell3
?3
4
Merck2
6
0
Wachovia1
?3
?8
a.If your forecast for next year is that the risk-free interest rate next year will be 1.0 percent, the overall stock market will return 10.0 percent, the unemployment rate will be 5.0 percent, and the real federal funds rate will be 2.0 percent, what is the expected return (in percent, with two decimals) to each of the three stocks? Show your calculations. b.If your forecast for next year is that the risk-free interest rate next year will be 2.0 percent, the overall stock market will return 20.0 percent, the unemployment rate will be 4.0 percent, and the real federal funds rate will be 4.0 percent, what is the expected return (in percent, with two decimals) to each of the three stocks? Show your calculations.
What will be an ideal response?
a.From the APT equation Rit = rt + ?1if 1t + ?2if 2t + ... + ?k if kt + ?it, we use the expected return E(R it) = rt + ?1if 1t + ?2if 2t + ... + ?k if kt. Royal DutchShell:1.0% + [3 × (10.0% ? 1.0%)] + [?3 × (5.0% ? 4.5%)] + [4 × (2.0% ? 3.0%)] = 1.0% + 27.0% ? 1.5% ? 4% = 22.5% Merck:1.0% + [2 × (10.0% ? 1.0%)] + [6 × (5.0% ? 4.5%)] + [0 × (2.0% ? 3.0%)] = 1.0% + 18.0% + 3.0% + 0% = 22.0% Wachovia:1.0% + [1 × (10.0% ? 1.0%)] + [?3 × (5.0% ? 4.5%)] + [?8 × (2.0% ? 3.0%)] = 1.0% + 9.0% ? 1.5% + 8.0% = 16.5% b.From the APT equation Rit = rt + ?1if 1t + ?2if 2t + ... + ?k i f kt + ?it, we use the expected return E(Rit) = rt + ?1if 1t + ?2if 2t + ... + ?k if kt. Royal DutchShell:2.0% + [3 × (20.0% ? 2.0%)] + [?3 × (4.0% ? 4.5%)] + [4 × (4.0% ? 3.0%)] = 2.0% + 54.0% + 1.5% + 4.0% = 61.5% Merck:2.0% + [2 × (20.0% ? 2.0%)] + [6 × (4.0% ? 4.5%)] + [0 × (4.0% ? 3.0%)] = 2.0% + 36.0% ? 3.0% + 0.0% = 35.0% Wachovia:2.0% + [1 × (20.0% ? 2.0%)] + [?3 × (4.0% ? 4.5%)] + [?8 × (4.0% ? 3.0%)] = 2.0% + 18.0% + 1.5% ? 8.0% = 13.5%
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