The predicted return uses the unemployment and interest rate surprises as follows:
The returns for a stock that are correlated with surprises in interest rates and unemployment rates can be expressed using a two-factor model as:
Ri = ai+ bi,1FInt + bi,2FUn + εi
where:
Ri = the return on stock i
ai = the expected return on stock i
bi,1 = the factor sensitivity of stock i to unexpected changes in interest rates
FInt = unexpected changes in interest rates (the interest factor) = .053 − .051 = .002
bi,2 = the factor sensitivity of stock i to unexpected changes in the unemployment rate
FUn = unexpected changes in the unemployment rate (the unemployment rate factor) = .072 − .068 = .004
εi = a mean-zero error term that represents the part of asset i’s return not explained by the two factors.
Thus the predicted return is: 0.11 + (1.0)(0.002) + (1.2)(0.004) = 0.1168 or 11.68
