Research has identified two systematic factors that affect US stock (share) returns. The factors are growth in industrial production and changes in long term interest rates. Industrial production growth is expected to be 3% and long term interest rates are expected to increase by 1%. You are analysing a share that has a beta of 1.2 on the industrial production factor and 0.5 on the interest rate factor. It currently has an expected return of 12%. However, if industrial production actually grows 5% and interest rates drop 2% what is your best guess of the share's return?
A)15.9%
B)12.9%
C)13.2%
D)12.0%

Question

Quizplus · Accepted Answer

First, we calculate the impact of the changes in the two factors on the share's return:

- Growth in industrial production goes from 3% to 5%, which is a 2% increase. The impact on the share's return is 1.2 * 2% = 2.4%.
- Changes in long term interest rates go from +1% to -2%, which is a 3% decrease. The impact on the share's return is 0.5 * (-3%) = -1.5%.

Therefore, the overall impact on the share's return is 2.4% - 1.5% = 0.9%.

Next, we add this impact to the share's initial expected return of 12%.

So, the best guess for the share's return would be 12% + 0.9% = 12.9%.

Therefore, the answer is B.

Research Has Identified Two Systematic Factors That Affect US Stock