1.

Use the following facts for (all parts of) this problem:

• There is only one factor that affects stock returns, and it is the growth in industrial production

• There are three possible states of the world: Ugly, Bad and Good. We know exactly how much
return the following three securities (A, B and C) will yield in each of the possible states:

State Ugly Bad Good

Probability 1/3 1/3 1/3

Growth in production 0% 5% 10%

Stock A 16% 6% -4%

Stock B 4% 9% 14%

Stock C 2% 12% 22%

• Securities A, B and C sell for 50 rupees each

(a) Calculate the values of F (unanticipated growth in industrial production) for the only factor in all
three states

 F= next quarters growth in industrial production – expected growth in industrial

production
o Expected growth in industrial production : 1/3 * 0 + 1/3 * 0.05 + 1/3 * 0.1 =
0.05
 Fugly = 0 - 0.05 = -0.05
 Fbad = 0.05 – 0.05 = 0
 Fgood = 0.1-0.05 = 0.05

(b) Calculate from the above table, the expected returns of each of the three securities, and their
factor sensitivities to the industrial production factor

 Ri = E(ri) + b * F
 E(ri)
o E(rA): 0.06 = E(rA) + bA*0 E(rA) = 0.06
 o E(rB): 0.09 = E(rB) + bB*0 E(rB) = 0.09
o E(rC): 0.12 = E(rC) + bC*0 E(rC) = 0.12
 Bèta (b)
o BA: 0.16 = 0.06 + bA * (-0.05) bA = -2
o BB: 0.04 = 0.09 + bB * (-0.05) bB = 1
o BC: 0.02 = 0.12 + bC * (-0.05) bC = 2

(c) Using only securities A and B, calculate the implied risk-free rate, and the factor premium for the
industrial production factor

0.06 = rf – 2*F rf = 0.06 + 2*F rf = 0.08

0.09 = rf + 1*F 0.09 = 0.06 + 3*F + 1*F F = 0.01

(d) Now, using only securities A and C, calculate the implied risk-free rate, and the factor premium
for the industrial production factor

0.06 = rf – 2*F rf = 0.06 + 2*F rf = 0.15

0.12 = rf + 1*F 0.12 = 0.06 + 3*F + 1*F F = 0.045

(e) Comparing your answers from (c) and (d) above, is there an arbitrage opportunity in this
economy?

 Yes, there is an opportunity to arbitrate the market by (short-)selling C in favour of

buying stock C, because the risk-free rate in an A-C centered market is 15% where
this is only 8% in an A-B centered market.