(All Ques are independent) Assume that a three-factor APT describes the returns of all well-diversified portfolios, and that the three factors are unexpected changes in production (factor 1), a default spread factor (factor 2), and a Treasury term-spread factor (factor 3). Because of recent adverse events, over the next year, the market expects production to grow only by 1.5%, default spread to be 3.0%, and the term spread to be 1.8%. The pricing relationships for all well diversified portfolios are given by:

E(rA) = 0.05 + Bi1 X 0.07 + Bi2 X 0.05 - Bi3 X 0.04 (B here represents Beta)

All investors can borrow or lend at the risk free rate of 5%. Sigma(factor₁) = Sigma (factor₂) = Sigma (factor₃) = 0.15. For simplicity, assume that the coefficient of correlation between any two factors is 0. The return process for portfolio A (which is well diversified) over the next year is:

rA = E(rA) + 1.2f1 + 0.5f2 - 0.5f3

5.a. What is the expected return portfolio A? (1 point)

5.b. What is the standard deviation of portfolio A? (1 point)

5.c. If production grows by 3% over the next year, the default spread falls to 2.75%, and the term spread does exactly what the market expects, what will be the return on the portfolio A? (1 point)

5.d. Assume you are using the same original factors (i.e. same economy). You are considering investing in an actively managed fund ChigaBiga. The residual standard deviation _(e)= 11%. The real return-generating process for ChigaBiga is: r = 0.08 + 2f1 + f2 - 0.4f3 + e

Whats the equilibrium expected return for ChigaBiga based on its risk exposure? (1 point)

5.e. According to your calculation in 5.d., you should: (1 point)

1. Buy ChigaBiga because it is overpriced
2. Sell ChigaBiga because it is overpriced
3. Buy ChigaBiga because it is underpriced

D. Sell ChigaBiga because it is underpriced