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Unformatted text preview: t the returns of the firm in which you are interested, but they will have no effect on the returns of firms in a different industry and perhaps little effect on other firms in the same industry. Any return can be explained with a large enough number of systematic risk factors. However, for a factor model to be useful as a practical matter, the number of factors that explain the returns on an asset must be relatively limited. The market risk premium and inflation rates are probably good choices. The price of wheat, while a risk factor for Ultra Products, is not a market risk factor and will not likely be priced as a risk factor common to all stocks. In this case, wheat would be a firm specific risk factor, not a market risk factor. A better model would employ macroeconomic risk factors such as interest rates, GDP, energy prices, and industrial production, among others. a. b. c. d. Real GNP was higher than anticipated. Since returns are positively related to the level of GNP, returns should rise based on this factor. Inflation was exactly the amount anticipated. Since there was no surprise in this announcement, it will not affect Lewis-Striden returns. Interest rates are lower than anticipated. Since returns are negatively related to interest rates, the lower than expected rate is good news. Returns should rise due to interest rates. The President’s death is bad news. Although the president was expected to retire, his retirement would not be effective for six months. During that period he would still contribute to the firm. His untimely death means that those contributions will not be made. Since he was generally considered an asset to the firm, his death will cause returns to fall. However, since his departure was expected soon, the drop might not be very large. The poor research results are also bad news. Since Lewis-Striden must continue to test the drug, it will not go into production as early as expected. The delay will affect expected future earnings, and thus it will dampen returns now. The research breakthrough is positive news for Lewis Striden. Since it was unexpected, it will cause returns to rise. 2. 3. 4. e. f. g. The competitor’s announcement is also unexpected, but it is not a welcome surprise. This announcement will lower the returns on Lewis-Striden. The systematic factors in the list are real GNP, inflation, and interest rates. T he unsystematic risk factors are the president’s ability to contribute to the firm, the research results, and the competitor. 5. The main difference is that the market model assumes that only one factor, usually a stock market aggregate, is enough to explain stock returns, while a k-factor model relies on k factors to explain returns. The fact that APT does not give any guidance about the factors that influence stock returns is a commonly-cited criticism. However, in choosing factors, we should choose factors that have an economically valid reason for potentially affecting stock returns. For example, a smaller company has more risk than a large company. Therefore, the size of a company can affect the returns of the company stock. Assuming the market portfolio is properly scaled, it can be shown that the one-factor model is identical to the CAPM. It is the weighted average of expected returns plus the weighted average of each security's beta times a factor F plus the weighted average of the unsystematic risks of the individual securities. Choosing variables because they have been shown to be related to returns is data mining. The relation found between some attribute and returns can be accidental, thus overstated. For example, the occurrence of sunburns and ice cream consumption are related; however, sunburns do not necessarily cause ice cream consumption, or vice versa. For a factor to truly be related to asset returns, there should be sound economic reasoning for the relationship, not just a statistical one. 6. 7. 8. 9. 10. Using a benchmark composed of English stocks is wrong because the stocks included are not of the same style as those in a U.S. growth stock fund. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. Since we have the expected return of the stock, the revised expected return can be determined using the innovation, or surprise, in the risk factors. So, the revised expected return is: R = 11% + 1.2(3.2% – 3.5%) – 0.8(3.4% – 2.9%) R = 10.24% 2. a. If m is the systematic risk portion of return, then: m = β GNPΔGNP + β InflationΔInflation + β rΔInterest rates m = .0000479($13,601 – 13,275) – 1.30(3.20% – 3.90%) – .67(4.70% – 5.20%) m = 2.81% 297 b. The unsystematic return is the return that occurs because of a firm specific factor such as the bad news a...
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