You are planning to buy a stock, the risk on which is dependent on two factors: (1) the change in the inflation rate over the last year and (2) the spread between ten-year Treasury bonds and three-month Treasury bills.Suppose the average risk-free interest rate is 3 percent.The beta coefficients of the stock associated with the change in inflation rate and the spread between ten-year Treasury bonds and three-month Treasury bills are -2 and 4 respectively.If you expect the inflation rate to rise 6 percentage point and you think the spread will be 8 percentage points.What is the expected return to this stock? Use the arbitrage-pricing theory.

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Quizplus · Accepted Answer

The expected return using the arbitrage pricing theory (APT) can be calculated as follows: Expected Return = Risk-Free Rate + (Beta1 * Factor1) + (Beta2 * Factor2). Here, Risk-Free Rate = 3%, Beta1 (change in inflation rate) = -2, Factor1 (expected change in inflation) = 6%, Beta2 (spread between bonds) = 4, and Factor2 (expected spread) = 8%. Thus, Expected Return = 3% + (-2 * 6%) + (4 * 8%) = 3% - 12% + 32% = 23%.

You Are Planning to Buy a Stock, the Risk on Which