In accordance with the

Arbitrage Pricing Theory, assume that stock returns can be explained by the

following four factor model:

E(R)=

RF + 1F1 + 2F2 + 3F3

+ 4F4

Below please find betas

for each of four stocks as follows; assume there is no firm specific risk.

Stock

1

2

3

4

A

1.25

.70

.08

.65

B

.65

1.40

-.45

.85

C

.75

-.20

1.30

-.15

D

-.35

.80

1.20

1.45

The risk premiums for

the factors are 6.2%, 5.7%, 3.9% and 7.0% respectively. If you create a portfolio comprised of 25% of

Stock A, 15% of Stock B, and 30% each of Stocks C and D, what is the equation

for your model? Assuming a risk-free

rate of 6%, what is the expected return on your portfolio?

Assume that the factors

in this model include the following:

Real growth in GDP (F1), unexpected inflation (F2),

change in interest rates (F3), and change in expected inflation (F4). What do the signs and magnitude of the

corresponding betas tell you about the stocks in this portfolio?

Factor models are one

method of assessing risk and return, the Capital Asset Pricing Model (CAPM) is

another. How does this method that you

have used above differ from the CAPM?

Under what conditions would you obtain the same expected return using

either method?