1.

Use the following facts for (all parts of) this problem:

• There is only one factor that affects stock returns, and it is the growth in industrial production

• There are three possible states of the world: Ugly, Bad and Good. We know exactly how much
return the following three securities (A, B and C) will yield in each of the possible states:

State Ugly Bad Good

Probability 1/3 1/3 1/3

Growth in production 0% 5% 10%

Stock A 16% 6% -4%

Stock B 4% 9% 14%

Stock C 2% 12% 22%

• Securities A, B and C sell for 50 rupees each

(a) Calculate the values of F (unanticipated growth in industrial production) for the only factor in all
three states

(b) Calculate from the above table, the expected returns of each of the three securities, and their
factor sensitivities to the industrial production factor

(c) Using only securities A and B, calculate the implied risk-free rate, and the factor premium for the
industrial production factor

(d) Now, using only securities A and C, calculate the implied risk-free rate, and the factor premium
for the industrial production factor

(e) Comparing your answers from (c) and (d) above, is there an arbitrage opportunity in this
economy?

(15 points)
Answear :

a)

State Ugly Bad Good

Growth in
0% 5% 10%
production
Expected Growth 0.00% 1.67% 3.33%
Unantecipated
0.00% 3.33% 6.67%
shock

b)

Multiplying the return in each state by its probability and calculating the betas we have

Ugly Bad Good Total Beta

Stock A 5.33% 2.00% -1.33% 6.00% -2
Stock B 1.33% 3.00% 4.67% 9.00% 1
Stock C 0.67% 4.00% 7.33% 12.00% 2

c)

Return = Rf + Beta * RFP

0.06 = Rf – 2 * RFP

0.09 = RF + 1 * RFP

Solving these equations we get :

RFP = 0.01 and Rf = 0.08

d)

0.06 = Rf – 2* RFP

0.12 = Rf + 2 * RFP

Solving these equations we get:

RFP = 0.02 and Rf = 0.08

e)
Yes there is an arbitrage opportunity since we get different RFPs.