1. (20 points) As an informed student of Econ 173A, you begin to become concerned about firm-specific risk. As such you investigate well-diversified index funds. Your research brings to you Domestic Debt Index (D) and European Exchange Rates Index (E), and you identify a mispricing of one of the index funds. These funds have the following expected returns Er and sensitivities B to the overall market. E[rd] = 9% Ere) = 10% Bp = 2/5 Be = 8/5 The expected market return is Erm) = 8%, and the risk-free rate is 4%. (a) (2 points) Which of the index fund(s) do you find to be mispriced? Justify your answer with the both funds' alphas. Hint: It might be more than one. (b) (3 points) In each case of mispricing, is the fund overpriced or underpriced? Justify your answer with the funds alphas. (c) (15 points total) You are able to borrow or lend at the risk-free rate (if necessary). Describe an arbitrage strategy by which you short one fund and buy the other. Your answer should include the following: i. (3 points) Which fund do you short and which do you buy? ii. (2 points) How much do you borrow/lend at the risk-free rate? iii. (8 points) What is your percentage return from this arbitrage opportunity? Hint: In the case of two nonzero alphas with different signs (one positive, one nega- tive), buying/selling more or less of one than the other will never change the arbitrage strategy as it did in midterm 2