Security returns depend on only three risk factors-inflation, industrial production and the aggregate degree of risk aversion.
Question:
Security returns depend on only three risk factors-inflation, industrial production and the aggregate degree of risk aversion. The risk free rate is 8% the required rate of return on a portfolio with unit sensitivity to inflation and zero-sensitivity to other factors is 13.0% the required rate of return on a portfolio with unit sensitivity to industrial production and zero sensitivity to inflation and other factors is 10% and the required return on a portfolio with unit sensitivity to the degree of risk aversion and zero sensitivity to other factors is 6%. Security I has betas of 0.9 with the inflation portfolio, 1.2 with the industrial production and -0.7 with risk bearing portfolio –(risk aversion) Assume also that required rate of return on the market is 15% and stock I has CAPM
beta of 1.1Required
Compute security is required rate of return using (10 marks)
i. CAPM
ii. APT
Expert Answer:
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