Problem 2 (20 marks) Consider a two factor economy. Assume the risk-free rate = 3%, and the risk premiums are RP 1 = 10%, RP 2 = 8%.

Problem 2 (20 marks)

Consider a two factor economy. Assume the risk-free rate = 3%, and the risk premiums are RP1 = 10%, RP2 = 8%. The return on stock ABC is generated according to the following equation:

rABC.08-0.55F1+1.2F2+eABC

Assume that the stock is currently priced at $50 per share.

• What is the expected return for stock ABC using the APT? Is stock ABC underpriced or overvalued? If the expected price next year will be $55, what is the stock price now that will not allow for arbitrage profits?
• Assume that the risk free rate increases to 4%, with the other variables remaining unchanged.  Would you recommend to buy or sell stock ABC?

Problem 2 (20 marks)Consider a two factor economy. Assume the risk-free rate = 3%, and the risk premiums areRP1 = 10%, RP2 = 8%. The return on stock ABC is generated according to the following...