Explanation

In Arbitrage Pricing Theory (APT), the expected return is calculated using the formula:

Expected Return = Risk-free rate + Σ(Beta_i × Risk Premium_i)

Given:

• Risk-free rate = 2%
• Factor betas and risk premiums:
  • Probability of default: Beta = 0.5, Premium = 2%
  • Daily trading volume: Beta = -0.2, Premium = -1%
  • Earnings growth forecast: Beta = 1.5, Premium = 1.5%

Calculation:

1. Risk-free rate component: 2%
2. Probability of default component: 0.5 × 2% = 1%
3. Trading volume component: -0.2 × (-1%) = 0.2%
4. Earnings growth component: 1.5 × 1.5% = 2.25%

Total expected return: 2% + 1% + 0.2% + 2.25% = 5.45% ≈ 5.5%

Therefore, the correct answer is C. 5.5%.