Consider an economy where the market can be described by three sources of systematic risk (F1,
F2, and F3) with associated risk premiums RP1 = 5%, RP2 = 2%, and RP3 = 4%. The return on stock ABC is generated according to the following equation:
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?