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3. Consider the stochastic version of the arbitrage pricing model, where R; (the return of the ith asset) is related to the factors F and
3. Consider the stochastic version of the arbitrage pricing model, where R; (the return of the ith asset) is related to the factors F and F2 as follows: R = a + b F1 + b2F2+ Ei, where ; is a random "noise" term with zero mean and variance o? > 0. (a) For three assets (1, 2 and 3), derive the weights x1, x2 and x3 so that the portfolio has a return x R1 + x2R2 + x3R3 that does not depend on the two factors. You can assume that the b's are such that the relevant arithmetic operations will not result in the "division by zero" problem. (b) Explain whether the portfolio you find in part (a): i. is risk free; ii. should earn the risk-free return rate. C11
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