In accordance with the Arbitrage Pricing Theory

  

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

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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?

  

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