Suppose that the market can be described by the following three sources of systematic risk with...

Suppose that the market can be described by the following three sources of systematic risk with associated risk premiums.

Factor	Risk Premium
Industrial production (I)	9	%
Interest rates (R)	5	%
Consumer confidence (C)	7	%

The return on a particular stock is generated according to the following equation:

r = 11% + 1.0I + 0.4R + 0.70C + e

a-1. Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 9%. (Do not round intermediate calculations. Round your answer to 1 decimal place.)

a-2. Is the stock over- or underpriced?

multiple choice

Overpriced
Underpriced

Expert Solution

1.
=9%+1*9%+0.4*5%+0.7*7%
=24.9000%

2.
According to the equation for the return on the stock, the actually expected return on the stock is 11% (because the expected surprises on all factors are zero by definition). Because the actually expected return based on risk is less than the equilibrium return, we conclude that the stock is overpriced.

jeff jeffy answered 2 years ago

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