APT Assume that the following market model adequately describes the returngenerating behavior of risky assets:

R it 5 a i 1 b i R M t 1 e it Here:

R it 5 The return on the i th asset at Time t.

R M t 5 The return on a portfolio containing all risky assets in some proportion at Time t.

R M t and e it are statistically independent.

Short selling (i.e., negative positions) is allowed in the market. You are given the following information:

Asset bi E(Ri ) Var(????i )

A .7 8.41% .0100 B 1.2 12.06 .0144 C 1.5 13.95 .0225 The variance of the market is .0121, and there are no transaction costs.

a. Calculate the standard deviation of returns for each asset.

b. Calculate the variance of return of three portfolios containing an infinite number of asset types A , B , or C , respectively.

c. Assume the risk-free rate is 3.3 percent and the expected return on the market is 10.6 percent. Which asset will not be held by rational investors?

d. What equilibrium state will emerge such that no arbitrage opportunities exist?

Why?