A two-factor APT (Arbitrage Pricing Theory) describes the returns of all well-diversified

U.S. portfolios. The two factors are unexpected growth in U.S. Gross Domestic Product

(factor 1), and a U.S. inflation factor (factor 2).

The prices of all well-diversified portfolios are set so that their expected returns over the

next year are given by:

,1 ,2 ( ) 0.05 0.08 0.06 i i i E r = + b b , where i ,1 b and i ,2 b are the sensitivities of

portfolio i to factors 1 and 2 respectively

The market believes that the standard deviations of 1 f and 2 f are both 0.10 (10%), and

that the two factors are uncorrelated with each other.

a. (3 points) Find the risk-free rate and the factor risk premiums for each factor in this

economy