Question

David McLemore, the CFO of Ultra Bread, has decided to use an APT model to estimate the required return on the company's stock. The risk factors he plans to use are the risk premium on the stock market, the inflation rate, and the price of wheat. Because wheat is one of the biggest costs Ultra Bread faces, he feels this is a significant risk factor for Ultra Bread. How would you evaluate his choice of risk factors? Are there other risk factors you might suggest?

200 words required

Answer 1

Let's understand a little bit about APT first.

• The Arbitrage Pricing Theory (APT) and the Fama-French model are alternatives to Capital Asset Pricing Model (CAPM).
• APT is a general theory of asset pricing that holds that the expected return of a financial asset can be modelled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
• It is a multi-factor model in comparison to CAPM which is a single factor model. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors.
• Arbitrageurs use the APT model to profit by taking advantage of mispriced securities.

David McLemore, the CFO of Ultra Bread, has decided to use an APT model to estimate the required return on the company's stock. The risk factors he plans to use are the risk premium on the stock market, the inflation rate, and the price of wheat.

Out of the risk factors chosen by him, the following two factors are good choices

• The market risk premium and
• inflation rates.

The choice of the third factor i.e. the price of wheat doesn't have any basis for appreciation. This is because:

• The price of wheat is not a market risk factor and
• This factor will not be a common risk factor for all stocks.
• The price of wheat heere is actually a firm specific risk factor

Suggestions:

CFO may like to choose any of the following factors for better estimation in addition to the two factors above namely the market risk premium and inflation:

• GDP growth rate
• interest rates
• Oil & gas or energy prices
• and industrial production