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CMA Final · Strategic Financial Management · Asset Pricing Theories

Under a single-factor APT model, the risk-free rate is 5% and the factor risk premium is 4% per unit of factor sensitivity. Stock Bharat Auto has a factor sensitivity of 1.5 and a quoted expected return of 10.5%. Which statement is correct?

The fair return is 11% and the stock is overpriced. APT gives 5% plus 1.5 times 4%, equal to 11%. The stock offers only 10.5%, below the fair return, so its price is too high and it should be sold.

  1. AFair return is 11%; the stock is overpriced as it offers less than fair returnCorrect
  2. BFair return is 11%; the stock is underpriced as it offers less than fair return
  3. CFair return is 6%; the stock is underpriced
  4. DFair return is 10.5%; the stock is fairly priced

Explanation

APT fair return = 5% + 1.5 x 4% = 11%. The offered return of 10.5% is below this, so the price is too high and the stock is overpriced, and arbitrageurs would sell it. Option with 6% uses only the premium term 1.5 x 4% without the risk-free rate. The second option has the right return but wrong conclusion.

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