Question

# Consider an economy where the market can be described by three sources of systematic risk (F_{1},

F_{2}, and F_{3}) with associated risk premiums RP_{1} = 5%, RP_{2} = 2%, and RP_{3} = 4%. The return on stock ABC is generated according to the following equation:

r_{ABC}=0.13+1.0F_{1}+0.5F_{2}+0.75F_{3}+e_{ABC}

Assume that the stock is currently priced at $50 per share and T-bill rate is 5%.

1. What is the equilibrium rate of return for stock ABC using the APT?

2. Is stock ABC underpriced or overvalued? Explain

3. If the expected price next year will be $56, what is the stock price now that will not allow for arbitrage profits?

4. Assume that the T-bill rate decreases to 3%, with the other variables remaining unchanged. Would you recommend to buy or sell stock ABC?

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