You have been assigned the task of estimating the expected returns for three different stocks: QRS, TUV, and WXY. Your preliminary analysis has established the historical risk premiums associated with three risk factors that could potentially be included in your calculations: the excess return on a proxy for the market portfolio (MKT), and two variables capturing general macroeconomic exposures (MACRO1 and MACRO2). These values are: λMKT = 7.5%, λMACRO1 = −0.3%, and λMACRO2 = 0.6%. You have also estimated the following factor betas (i.e., loadings) for all three stocks with respect to each of these potential risk factors:

a. Calculate expected returns for the three stocks using just the MKT risk factor. Assume a risk-free rate of 4.5%.
b. Calculate the expected returns for the three stocks using all three risk factors and the same 4.5% risk-free rate.
c. Discuss the differences between the expected return estimates from the single-factor model and those from the multifactor model. Which estimates are most likely to be more useful in practice?
d. What sort of exposure might MACRO2 represent? Given the estimated factor betas, is it really reasonable to consider it a common (i.e., systematic) riskfactor?

  • CreatedDecember 17, 2014
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