Question
APT 6. Assume that the single index model holds for all securities and an investor comes up with the following equation for the return of
APT
6. Assume that the single index model holds for all securities and an investor comes up with the
following equation for the return of the well diversified portfolio P:
rP = 17% +0.8Rm,
where Rm is an excess return on the market. The risk free rate is 2% and the market expected
return is 10%.
a. Does APT hold for portfolio P?
b. Does an arbitrage opportunity exist in this economy? If so, what would be an arbitrage
strategy?
c. Now suppose that portfolio P is not welldiversified so that
rP = 17% + 0.8Rm + eP
where eP
is unexpected contribution from portfolio specific risk to the return of P. Does an
arbitrage opportunity exist? Why? If yes, what is an arbitrage strategy?
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