Consider two well-diversified portfolios A and B that conform to a two-factor

model (the two shocks to factors, F1,t and F2,t, have zero means), that is, their alphas are equal to

zero, and the risk-free rate (assume that you may both lend and borrow at the risk-free rate). All

returns are expressed in percentage points:

rA,t = 10.4 + 0.5 F1,t + 0.7 F2,t ; rB,t = 20.3 + 1.5 F1,t + 1.4 F2,t ; rf = 3.

a) Write the expressions for the expected rates of return on portfolios A and B according to

the two-factor model (Hint: The general form is E(rX) = rf + X,1 1 +X,2 2; use all the specific

quantities as given above).

b)What is the risk premium per unit of factor-1 risk, 1? What is the risk premium per unit

of factor-2 risk, 2 (Hint: Use the two expressions developed under a) to set up a system of equations

and solve for 1 and 2)