Financial Risk Manager Part 1

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Suzy Ye is a junior equity research analyst at a research firm based in South Korea. For the first time, she is using the multifactor model to compute the stock return of the Wong Kong Corp (WK). She has compiled the following data for the computation of the return:

Wong Kong's expected stock return: 7%
Expected GDP growth: 4.5%
Expected Inflation: 2.5%
GDP factor beta: 1.5
Inflation factor beta: 2
Risk-free rate: 2%

Suppose the actual GDP growth and actual inflation of South Korea are 3% and 2.9%, respectively, then which of the following is an accurate estimate of the stock return?

Other

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TTanishq

7.55%

10.05%

5.55%

18.75%

Explanation:

Explanation

This question involves a multifactor model (2-factor model) to calculate stock returns. The formula for the multifactor model is:

$R_{WK} = E(R_{WK}) + \beta_{GDP}F_{GDP} + \beta_I F_I$

Where:

$E(R_{WK}) = 7\% = 0.07$ (expected stock return)
$\beta_{GDP} = 1.5$ (GDP factor beta)
$\beta_I = 2$ (Inflation factor beta)
$F_{GDP} = \text{Actual GDP} - \text{Expected GDP} = 3\% - 4.5\% = -1.5\% = -0.015$
$F_I = \text{Actual Inflation} - \text{Expected Inflation} = 2.9\% - 2.5\% = 0.4\% = 0.004$

Now substituting the values:

$R_{WK} = 0.07 + 1.5(-0.015) + 2(0.004)$ $R_{WK} = 0.07 - 0.0225 + 0.008$ $R_{WK} = 0.0555 = 5.55\%$

The calculation shows that the actual stock return is 5.55%, which is lower than the expected return of 7% due to the negative surprise in GDP growth (actual GDP of 3% was lower than expected 4.5%), which had a larger negative impact than the positive surprise in inflation.

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