Explanation

This is a multi-factor model question where we need to calculate the expected return based on macroeconomic factor shocks.

Given:

• Baseline expected return: 5.0%
• Factor betas:
  • βIndustrial production = 1.30
  • βInterest rate = -0.75
• Baseline scenario:
  • Industrial production growth = 3.0%
  • Interest rate = 1.5%
• Forecast scenario:
  • Industrial production growth = 4.2%
  • Interest rate = 1.75%

Step 1: Calculate the shocks (deviations from baseline)

• Industrial production shock = 4.2% - 3.0% = 1.2%
• Interest rate shock = 1.75% - 1.5% = 0.25%

Step 2: Calculate the impact of each shock

• Industrial production impact = βIndustrial production × Industrial production shock = 1.30 × 1.2% = 1.56%
• Interest rate impact = βInterest rate × Interest rate shock = -0.75 × 0.25% = -0.1875%

Step 3: Calculate total expected return Total expected return = Baseline return + Industrial production impact + Interest rate impact = 5.0% + 1.56% + (-0.1875%) = 5.0% + 1.56% - 0.1875% = 6.3725% ≈ 6.37%

Step 4: Compare with options 6.37% is closest to option B (6.4%)

Key Concept: In multi-factor models, the expected return equals the baseline return plus the sum of (factor beta × factor shock) for each factor.