Explanation:
The first step is to determine the expected excess return for each element by subtracting the risk-free rate from the expected return, as shown below:
Factor A: $6.5% - 3.20% = 3.30%7.7\% - 3.20\% = 4.50\%$ Factor C:
Multiplying the relevant factor betas for ABC Bank stock yields the factor exposures’ contribution to the stock’s projected return:
0.88` \times 3.30% + (-0.55) \times 4.50% + 1.40 \times 0.80% = 1.549%
The total expected return for ABC Bank stock is calculated by adding the alpha and risk-free rate to the stock’s expected return from its factor exposures, yielding `$1.54`9\% + 0.60\% + 3.20\%$ for a total expected return of `$5.34`9\%$.Ultimate access to all questions.
Q.5320 An equities analyst at an asset management business is evaluating a prospective investment in ABC Bank stock using an internal three-factor model. Each of the three factors is represented by an exchange-traded fund (ETF) with a factor beta of one and a factor beta of zero for the others. The analyst gathers the following data:
| Factor A | Factor B | Factor C | |
|---|---|---|---|
| Expected annual return of ETF factor | 6.5% | 7.7% | 4.0% |
| Factor beta for ABC Bank stock | 0.88 | –0.55 | 1.40 |
What is the predicted yearly return on ABC Bank shares using the internal model if the annualized risk-free interest rate is 3.20% and the alpha is 0.60%?
A
1.549%
B
5.349%
C
4.749%
D
2.149%
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