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CFA Level I · CFA Level I Exam · The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models

A two-factor APT model has a risk-free rate of 3.0%, a factor 1 risk premium of 4.0% and a factor 2 risk premium of 2.0%. A stock has a factor 1 sensitivity of 1.2 and a factor 2 sensitivity of 0.5. The stock's expected return is closest to:

The expected return is 8.8%. It equals the 3.0% risk-free rate plus 1.2 times 4.0% (4.8%) plus 0.5 times 2.0% (1.0%). Each factor sensitivity is multiplied by its own risk premium and the products are added to the risk-free rate.

  1. A7.8%
  2. B8.8%Correct
  3. C9.8%

Explanation

E(R) = 3.0% + 1.2×4.0% + 0.5×2.0% = 3.0 + 4.8 + 1.0 = 8.8%. Omitting the risk-free rate gives 5.8%, and adding 1.0 twice would not match the options; 7.8% arises from leaving out factor 2's premium contribution incorrectly.

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