APT exercises

1. Suppose we identified two factors Industrial production IP and Inflation rate IR as appropriate risk
factors. IP is expected to 3% and IR is expected to be 5%

Stock x has a beta of 1 on IP and .5 on IR and has an expected return of 12%.

Now IP grows by 5% and inflation is 8% , what you expect the return of X to be?

The revised estimate of the expected rate of return on the stock would be the old estimate plus
the sum of the products of the unexpected change in each factor times the respective
sensitivity coefficient, that is,
Revised estimate = 12% + [(1  5%-3%) + (.5  8%-5%)] = 15.5%
= 12% + [(1 x 2%) + (.5 x 3%)] = 15.5%

2. Suppose we identify two factors, F1 and F2 ,that we consider should used to determine returns.
Suppose the risk free rate is 6% and , for simplicity all firm specific risk is 45% .

Portfolio Beta F1 Beta F2 Expected return

A 1.5 2.0 31%
B 2.2 -0.2 27%

What is the expected return- beta relationship for this scenario.

E(rp) = rf + p1[E(r1)  rf ] + p2[E(r2) – rf]

We need to find the risk premium, RP, for each of the two factors; RP1 = [E(r1)  rf] and
RP2 = [E(r2)  rf]. To do so, the following system of two equations with two unknowns
must be solved:
. .31 = .06 + 1.5  RP1 + 2.0  RP2

. .27 = .06 + 2.2  RP1 + (–.2)  RP2

 The solution to this set of equations is
RP1 = 10% and RP2 = 5%

Thus, the expected return-beta relationship is

E(rp) = 6% + p1  10% + p2  5%

3. Suppose we have a one Factor (F) economy.

Portfolio E(r) Beta

A 12% 1.2
B 6% 0.0

Suppose there exists another portfolio, C, that is well diversified and has a beta of .6 and expected
return of 8%.

If arbitrage is possible, what would be the result?

The expected return of portfolio B equals the risk-free rate since its beta equals 0. Portfolio A’s
ratio of risk premium to beta is: (.12  .06)/1.2 = .05, whereas, portfolio C’s ratio is lower at
(.08 – .06)/.6 = .0333. This implies that an arbitrage opportunity exists.
For instance, you can create a portfolio G with beta equal to .6 (the same as C’s) by mixing
portfolios A and B in equal weights. The expected return and beta of G is then
G = w (1.2) + (1-w)0 = .6 …… w = .5
E(rG) = .5  12% + .5  6% = 9%

Comparing G to C, G has the same beta and higher return. Therefore, an arbitrage
opportunity exists by buying portfolio G and selling an equal amount of portfolio E. If you
do so, your profit will be

rG – rc = (9% + .6  F) – (8% + .6  F) = 1% Where F is the risk factor.

4. Suppose you have two well diversified portfolios, A and B. The expected returns are 12% and 9%
respectively. The economy has only one risk factor. Beta A is 1.2 and Beta B is 0.8.

Given these data, what is the risk free rate??

Substituting the portfolio returns and betas in the expected return-beta relationship, we obtain two
equations with two unknowns, the risk-free rate (rf) and the factor risk premium (RP):

12% = rf + (1.2 × RP)

9% = rf + (0.8 × RP)

Solving these equations, we obtain

rf = 3% and RP = 7.5%

5. Asume a single index(factor) model of the form :

Ri = α + βi (Rm) + ꬴ

Where Ri is excess returns and Rm is the markets excess returns. The risk free is 2% consider the
following data >

Security Beta Expected Return Residual standard

deviation
A 0.8 10% 25%
B 1.0 12% 10%
C 1.2 14% 20%

Assume there are an infinite number of securities identical to A B and C available for investment.

A) If the standard deviation on the market is 20% calculate the variance of returns For A, B and C.

B) If one forms a well diversified portfolio of type A securities what will be the mean and variance of the
excess returns.

C) Suppose you form well diversified portfolios using only B and c securities?

D) what about arbitrage?

 2 2 2 2
A)
σ =β σ M +σ (e )

σ 2A =(0. 82 ×202 )+252 =881

2 2 2 2
σ B=(1 . 0 ×20 )+10 =500

σ 2C =(1. 22 ×202 )+202 =976

B) If there are an infinite number of assets with identical characteristics, then a well-diversified
portfolio of each type will have only systematic risk since the nonsystematic risk will approach
zero with large n. Each variance is simply β2 × market variance:

Well-diversified σ2A=256
Well-diversified σ2B=400
Well-diversified σ2C=57

The mean will equal that of the individual (identical) stocks.

C) There is no arbitrage opportunity because the well-diversified portfolios all plot on the
security market line (SML). Because they are fairly priced, there is no arbitrage.

6. Consider an APT (multifactor) model for the following stock.

Factor Factor beta Factor risk premium

Inflation 1.2 6%
Industrial Production 0.5 8%
Oil prices 0.3 3%

a) Suppose a t-bill yield of 6%; what is the expected return if the stock is fairly priced.

B) Now suppose the factor data is as in the table belows. What will be the revised expected return?
 Factor Expected rate of change Actual Rate of Change
Inflation 5% 4%
Industrial production 3% 6%
Oil prices 2% 0%

a)

E(r) = 6% + (1.2 × 6%) + (0.5 × 8%) + (0.3 × 3%) = 18.1%

b)

Surprises in the macroeconomic factors will result in surprises in the return of the stock:
Unexpected return from macro factors =
[1.2 × (4% – 5%)] + [0.5 × (6% – 3%)] + [0.3 × (0% – 2%)] = –0.3%
E (r) =18.1% − 0.3% = 17.8%

Suppose you can describe the market by these systematic risk factors and their risk premiums.

Factor Risk Premium

Industrial Production (I) 6%
Interest Rates (R) 2%
Consumer Confidence (C) 4%

The return of a stock is estimated as :

r = 15% + 1.0 I + 0.5R + .75 C + ꬴ

What is the equilibrium rate of return on this stock using the APT and t bill yield of 6%.

The APT required (i.e., equilibrium) rate of return on the stock based on rf and the factor
betas is:
required E(r) = 6% + (1 × 6%) + (0.5 × 2%) + (0.75 × 4%) = 16%
According to the equation for the return on the stock, the actual expected return on the stock is
15% (because the expected surprises on all factors are zero by definition). Because
the actually expected return is less than the equilibrium return, we conclude that the
stock is overpriced.