Consider the following information on the estimated factor loadings for a two-factor APT model for three well-diversified portfolios.

Beta1 Beta2 E(r)

Port A 1.5 .3 .19

Port B .5 .5 .13

Port C .2 1.0 .14

The risk-free rate is 1% per annum. Beta1 is the factor loading on Factor 1 and Beta2 is the factor loading for factor 2; E(r) denotes the expected return.

Assume there are no transactions costs and that you can short the portfolios and borrow and lend at the risk-free rate (you can obviously go long in the portfolios too).

A. Is there an arbitrage opportunity with these three well-diversified portfolios (and the risk-free rate)? For this question, justify your answer by showing the three are not priced correctly relative to each other. (9 points)

B. If there is an arbitrage opportunity, describe one way in which you could exploit it; be precise about what you would buy and sell and in what quantities or proportions. (9 points)