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Assume that the following two-factor model describes returns of portfolios: i = rf+bi,111 +bi,2-12 Assume that the following three portfolios are observed: Portfolio Expected Return
Assume that the following two-factor model describes returns of portfolios: i = rf+bi,111 +bi,2-12 Assume that the following three portfolios are observed: Portfolio Expected Return ri A 10% B 1% -2% bil bi2 1 0 0 2 -1 1 (a) (5 points) According to APT, what are the APT factors 11 and 12 for this market? (b) (3 points) Now consider a portfolio D with the following characteristics: id = 15%, bp,1 = 2, bp,2 = 1. Is an arbitrage opportunity possible, according to APT? (c) (5 points) Construct a portfolio out of A, B, and C which has the same factor loadings as D. What are the weights on A, B, and C for this new portfolio (which we will call E)? (d) (2 points) How can we create an arbitrage portfolio out of D and E? That is, what is the weight on portfolio D and the weight on portfolio E such that their sum is a riskless profit? Hint: it is useful to consider a portfolio whose weights add up to zero
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