QUESTION TWO (15 MARKS)

1. Consider the following simplified APT model:

Factor	Expected Risk Premium
Market	6.4%
Interest Rate	-0.6%
Yield Spread	5.1%

Factor Risk Exposures
	Market	Interest Rate	Yield Spread
Stock	Stock(b1)	(b2)	(b3)
P	1.0	-2.0	-0.2
P2	1.2	0	0.3
P3	0.3	0.5	1.0

1. Calculate the expected return for the above stocks. Assume risk free rate is 5%. Consider a portfolio with equal investments in stocks P, P2 and P3 (3 Marks)
2. What are the factor risk exposures for the portfolio? (2 marks)
3. What is the portfolios expected return? (2 marks)

2. A project has the following forecasted cash flows:

Cash Flows
C0	C1	C2	C3
(100)	40	60	50

The estimated project beta is 1.5. the market return rm is 16%, and the risk-free rate r f is 7%.

1. Estimate the opportunity cost of capital and the projects PV (using the same rate to discount each cashflow). (2 Marks)
2. What are the certainty- equivalent cash flow to the expected cash flow in each year? (2 Marks)
3. What is the ratio of the certainty-equivalent cash flow to the expected cash flow in each year? (2 Marks)
4. Explain why this ration declines. (2 Marks)