A two factor model for the return for Security X is 2% - 3(CPI) + 2(GDP). If you forecast CPI to be 2% and GDP to be 6%, the expected return for Security X is
A) 20%.
B) 12%.
C) 2%.
D) 8%.

Question

Quizplus · Accepted Answer

To calculate the expected return for Security X, we can use the Fisher effect formula:
Expected return = nominal risk-free rate + expected inflation premium + expected real growth premium

Nominal risk-free rate = CPI forecast = 2%
Expected inflation premium = 0 (assuming the nominal risk-free rate already includes inflation)
Expected real growth premium = GDP forecast = 6%

Therefore, the expected return for Security X is:
Expected return = 2% + 0 + 6% = 8%

The correct answer is D.

A Two Factor Model for the Return for Security X