Question

A three factor APT has the following risk premiums (i.e. lambdas): RP1 = 5.2%, RP2 = 3.4%. At equilibrium, assets with no risk have expected returns of 1.3%. You are forecasting that a particular asset has the following risk: b1 = 0.4 and b2 = 0.7. This asset is currently selling for $37.75. If markets are in equilibrium, what is your forecast of the price of this asset one period from now?

Answer in dollars and cents.

Answer 1

Arbitrage pricing theory is a multifactor model as against CAPM which is a single factor model It capture only systematic risk.

APT Equation = Re = Rf + Factor RP1 x 1 + Factor RP2 x 2 + .... + Factor RPk x k

= Re = 1.3% + 5.2% x 0.4 + 3.4% x 0.7 = 5.76%

Expected return from Arbitrage pricing model is 5.76%.

Forecasted period end Price = Current Price (1 + Expected Return)

= $37.75 (1+5.76%)

= $39.9244