Value: 10.00 Points Suppose That Two Factors Have Been Ident

value: 10.00 points Suppose that two factors have been identified for

Suppose that two factors have been identified for the U.S. economy: the growth rate of industrial production (IP) and the inflation rate (IR). The expected values for these factors are an IP growth of 5% and an IR of 3.0%. A stock has a beta of 2.6 with respect to IP and 1.9 with respect to IR and is currently expected to provide a return of 13%. Given that industrial production actually grows by 7%, and the inflation rate turns out to be 6.0%, what is your revised estimate of the expected rate of return on the stock? (Do not round intermediate calculations. Round your answer to 1 decimal place. Omit the "%" sign in your response.)

Paper For Above instruction

The estimation of the expected rate of return on a stock considering multiple economic factors involves understanding how changes in these factors influence the stock's performance. In this scenario, the factors are the growth rate of industrial production (IP) and the inflation rate (IR). The initial expectations for these factors were an IP growth of 5% and IR of 3.0%, with the stock's expected return at 13%. However, actual changes occurred: IP grew by 7%, and IR increased to 6.0%. To revise the expected return, we utilize the multi-factor model, which considers the sensitivities (betas) of the stock to each factor and the deviations from the expected values.

Mathematically, the revised expected return (R*) can be calculated using the formula:

R* = Rinitial + βIP[(Actual IP growth) - (Expected IP growth)] + βIR[(Actual IR) - (Expected IR)]

Where:

  • Rinitial = 13% (initial expected return)
  • βIP = 2.6
  • βIR = 1.9
  • Actual IP growth = 7%
  • Expected IP growth = 5%
  • Actual IR = 6.0%
  • Expected IR = 3.0%

Applying the values into the formula, we get:

R = 13 + 2.6(7 - 5) + 1.9*(6 - 3)

Calculating the differences:

7 - 5 = 2

6 - 3 = 3

Substituting back:

R = 13 + 2.6 2 + 1.9 * 3

Calculating each component:

2.6 * 2 = 5.2

1.9 * 3 = 5.7

Final sum:

R* = 13 + 5.2 + 5.7 = 23.9

Therefore, the revised expected rate of return on the stock is 23.9%.

This significant increase reflects how sensitive the stock is to changes in industrial production and inflation, as indicated by its betas. Investors and analysts often use such models to update their expectations based on recent economic developments, enabling better-informed investment decisions. As shown, accounting for deviations from expected economic variables can result in substantial revisions to expected returns, emphasizing the importance of dynamic models in financial analysis.

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