CA Final · Advanced Financial Management · Portfolio Management
Under a two-factor APT model, the risk-free rate is 6%, the risk premium for factor 1 (GDP growth) is 4% and for factor 2 (inflation surprise) is 2%. A stock of Bharat Auto Ltd has sensitivities of 1.5 to factor 1 and 0.5 to factor 2. What is its expected return?
Expected return is 13%. It equals the risk-free rate of 6% plus 1.5 times 4% (6%) plus 0.5 times 2% (1%). Each factor sensitivity is multiplied by its own risk premium and the products are added to the risk-free rate.
- A13%Correct
- B12%
- C15%
- D7%
Explanation
Expected return = 6% + 1.5 x 4% + 0.5 x 2% = 6 + 6 + 1 = 13%. Option 12% results from omitting the factor 2 premium (6+6). Option 15% arises from adding the sensitivities incorrectly (using 1.5 x 4 + 0.5 x 4 +... ) and 7% counts only the factor 2 contribution with the risk-free rate.
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