6.The following question illustrates the APT. Imagine that there are only two macroeconomic factors. Investments X, Y, and Z have the following sensitivities to these two factors:

Investment b1b2

X 1.75.25

Y -1.002.00

Z 2.001.00

We assume that the expected risk premium is 4 percent on factor 1 and 8 percent on factor 2. Treasury bills obviously offer zero risk premium.

a.According to the APT, what is the risk premium on each of the three stocks?

b.Suppose you buy $200 of X and $50 of Y and sell $150 of Z. What is the sensitivity of your portfolio to each of the two factors? What is the expected risk premium?