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Suppose the market can be described by the following three sources of systematic risk. Each factor in the following table has a mean value of zero (so factor values represent realized surprises relative to prior expectations), and the risk premiums associated with each source of systematic risk are given in the last column.
Systematic Factor |
Risk Premium |
Industrial production, IP |
6% |
Interest rates, INT |
2 |
Credit risk, CRED |
4 |
The excess return, R , on a particular stock is described by the following equation that relates realized returns to surprises in the three systematic factors:
R 5 6% 1 1.0 IP 1 .5 INT 1 .75 CRED 1 e
Find the equilibrium expected excess return on this stock using the APT. Is the stock overpriced or underpriced?
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