(a) What is meant by a 'factor model of asset returns? Comment on the merits and drawbacks of factor models in studying the determination of asset returns. (b) Explain the relationship between factor models and the Arbitrage Pricing Theory (APT) of asset prices. Hence, write down and interpret the main prediction of the APT. [Note: a formal derivation of the APT prediction is not expected or required.] (c) The following information is provided for a stock market in which asset returns respond to two factors: bj2 Mj | bji 12% Asset 1 0.5 0.2 Asset 2 19% 1.0 -0.4 Notation: Mj = expected rate of return on asset j; bjk = rate of change of the return on asset j with respect to factor k; j, k = 1, 2. Assume that a risk-free asset is available with rate of return ro = 1%. (i) Assuming that the APT holds in this market, obtain the risk premium corresponding to each factor. (ii) Provide an interpretation for the risk premia in the context of the APT. = (iii) A third asset traded in the market is observed to yield an average return of 12% with b31 0.4 and 632 = 1.2 (where b31 and b32 denote the rates of change in the return on the third asset with respect to factors 1 and 2, respectively). What inferences, if any, can you draw about the market from this information