Question

A researcher has determined that a two-factor model is appropriate to determine the return on a stock. The factors are the percentage change in GNP and an interest rate. GNP is expected to grow by 5 percent and the interest rate is expected to be 4.5 percent. A stock has a beta of 2.7 on the percentage change in GNP and a beta of –.73 on the interest rate. If the expected rate of return on the stock is 13 percent, what is the revised expected return on the stock if GNP actually grows by 4.6 percent and the interest rate is 4.8 percent?

Answer 1

Revised Expected Return = expected return + Surprises in the risk factors

= expected return + $\sum_{i=1}^{n}$ [Beta_i * (Actual Rate_i - Expected Rate_i)]

= 13% + [2.7 * (4.6% - 5%)] + [(-0.73) * (4.8% - 4.5%)]

= 13% - 1.35% - 0.22% = 11.43%