β1i

β2i

β3i

Microsoft2

−1

1

Goldcrafters3

2

−1

State Farm0

−2

0

a.What is the expected return to each of the three stocks? Show your calculations. b.If the market’s excess return were to rise 10 percentage points in a particular year (that is, instead of the average of 7 percent, the market’s excess return will be 17 percent), what would you expect the effect to be on the return to each of the three stocks? Show your calculations. c.If the inflation rate was expected to rise 2 percentage points in a particular year (that is, instead of the average of 0 percent, the inflation rate will rise by 2 percentage points), what would you expect the effect to be on the return to each of the three stocks? d.If the interest-rate spread rose 2 percentage points in a particular year (that is, instead of the average of 2 percentage points, the interest-rate spread will be 4 percentage points), what would you expect the effect to be on the return to each of the three stocks?

What will be an ideal response?

a.From the APT equation Rit = rt + β1if 1t + β2if 2t + … + βkif kt + εit, we use the expected return E(Rit) = rt + β1if 1t + β2if 2t + … + βkif kt. Microsoft:1% + (2 × 7%) + (−1 × 0) + (1 × 2%) = 17% Goldcrafters:1% + (3 × 7%) + (2 × 0) + (−1 × 2%) = 20% State Farm:1% + (0 × 7%) + (−2 × 0) + (0 × 2%) = 1% b.The first factor is 17 percent instead of 7 percent. Microsoft:1% + (2 × 17%) + (−1 × 0) + (1 × 2%) = 37% Goldcrafters:1% + (3 × 17%) + (2 × 0) + (−1 × 2%) = 50% State Farm:1% + (0 × 17%) + (−2 × 0) + (0 × 2%) = 1% c.The second factor is 2 percent instead of 0 percent. Microsoft:1% + (2 × 7%) + (−1 × 2%) + (1 × 2%) = 15% Goldcrafters:1% + (3 × 7%) + (2 × 2%) + (−1 × 2%) = 24% State Farm:1% + (0 × 7%) + (−2 × 2%) + (0 × 2%) = −3% d.The third factor is 4 percent instead of 2 percent. Microsoft:1% + (2 × 7%) + (−1 × 0) + (1 × 4%) = 19% Goldcrafters:1% + (3 × 7%) + (2 × 0) + (−1 × 4%) = 18% State Farm:1% + (0 × 7%) + (−2 × 0) + (0 × 4%) = 1%