Assume that two-factor model holds and the two factors are the following:

Risk Premium ofa factor portfolio(%)

Factor: Business cycle

8%

Factor: inflation

2.5%

The return on a particular well-diversified portfolio A is generated according to the following equation

rA= 17% + 1.0I+ 2.0R

whereIandRare unanticipated components in business cycle rate of return and inflation rate, respectively. The T-bill rate is 1%.

Question 1: What is the expected rate of return of this portfolio according to the APT? Is the portfolio over or underpriced?

a. 14%. It is overpriced

b. 30%. It is overpriced

c. 14%. It is underpriced

d. 17%. It is fairly priced

e. 13%. It is underpriced

Question 2: Assume that you can trade T-bills, factor portfolio for business cycle, factor portfolio for inflation, and portfolio A. Which of the strategies below is an arbitrage?

a. Short portfolio A and use proceeds to buy portfolio C. Portfolio C should be comprised from a factor portfolio for business cycle with weight 1. Factor portfolio for inflation with weight 2 and T-bills with weight -2.

b. Short portfolio C and buy factor portfolio bur business cycle. Portfolio C should be comprised from a factor portfolio for inflation with weight 0.5 and T-bills with weight 0.5.

c. Short factor portfolio bur business cycle and buy portfolio C. Portfolio C should be comprised from a factor portfolio for inflation with weight 0.5 and T-bills with weight 0.5.

d. The market does not offer any arbitrage strategy

e. Short portfolio C and use proceeds to buy portfolio A. Portfolio C should be comprised from a factor portfolio for business cycle with weight 1. Factor portfolio for inflation with weight 2 and T-bills with weight -2.