Posted: April 8th, 2021

Arbitrage pricing theory and multifactor models of risk and return

1.      Suppose that two factors have been identified that explain the U.S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 3%, and IR 5%. A stock with a beta of 1 on IP and .5 on IR currently is expected to provide a rate of return of 12%. If industrial production actually grows by 5%, while the inflation rate turns out to be 8%, what is your revised estimate of the expected rate of return on the stock?

2.       The APT itself does not provide guidance concerning the factors that one might expect to determine risk premiums. How should researchers decide which factors to investigate? Why, for example, is industrial production a reasonable factor to test for a risk premium?

3.       If the APT is to be a useful theory, the number of systematic factors in the economy must be small. Why?

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