Seminar 4 Activity 21

SEMINAR 4: FRIDAY 7th NOVEMBER 2014
ASSET PRICING
Seminar Questions to be completed before class
1. Explain, using examples the difference between systematic risk and unsystematic risk.
2. Why is it useful to calculate returns on assets using either a one-factor model such as, CAPM or a multi-factor model such as, APT?
3. Answer questions 8 and 10 on page 316 of the Hillier et al. (2013) text.
4. Multifactor Model
The monthly return on an asset, Rs is determined by the following equation:
Rs = 0.0041 + 0.0136ßIP - 0.0001ß∆EI - 0.0006ßUI + 0.0072ßURP - 0.0052ßUBR
Where IP is the monthly growth in industrial production; ∆EI = change in expected inflation; UI = unanticipated inflation; URP = unanticipated change in the risk premium between risky bonds and default-free bonds; UBR = unanticipated change in the difference between the return on long-term government bonds and the return on short-term government bonds
Suppose a particular asset had the following betas: ßIP = 1.1, ß∆EI = 2, ßUI = 3, ßURP = 0.1, ßUBR = 1.6. Calculate the expected monthly return on the asset.
Monthly return

0.00946
Monthly % return

0.946
Annual return
=(1.00946)^12-1
0.119616721
Annual % return

11.96%

5. Using the information in the table below, calculate the factor risk premium.
Factor
Factor Risk (ß)
Expected Risk Premium (rfactor - rf) in %
SUM OF
Yield Spread
1.06
5.25
1.06*5.25
Interest Rates
-2.35
-0.82
2.35*0.82
Exchange Rates
-0.50
-0.82
0.5*0.82
GNP
0.25
0.61
0.25*0.61
Inflation
-0.50
-0.77
0.5*0.77
6. Suppose stock returns can be explained by the following three-factor model: Ri = Rf + ß1F1 + ß2F2 +ß3F3
Assume there is no firm specific risk. The betas for each factor for three stocks is presented in the following table: TOTAL:17.453%

ß1 ß2 ß3

Stock A
1.20
0.90
0.20
0.2(6%+1.2*5.5%+0.9*4.2%+0.2*4.9%)=3.47%
Stock B
0.80
1.40
-0.30
2.96%
Stock C
0.95
-0.05
1.50
11.019%
The risk premiums for the factors are 5.5%, 4.2%, and 4.9%, respectively. If you create a portfolio with 20%