Problem 7-12

Suppose that three stocks (A, B, and C) and two common risk factors (1 and 2) have the following relationship:

E(R_A) = (1.0)₁ + (0.7)₂

E(R_B) = (0.6)₁ + (0.5)₂

E(R_C) = (1.4)₁ + (0.9)₂

1. If ₁ = 4% and ₂ = 3%, what are the prices expected next year for each of the stocks? Assume that all three stocks currently sell for $30 and will not pay dividend in the next year. Do not round intermediate calculations. Round your answers to the nearest cent.

   Expected price for Stock A: $

   Expected price for Stock B: $

   Expected price for Stock C: $

2. Suppose that you know that next year the prices for Stocks A, B, and C will actually be $25.00, $20.54, and $21.07. Assume that you can use the proceeds from any necessary short sale. Determine the riskless, arbitrage investment to take advantage of these mispriced securities.

   In order to create a riskless arbitrage investment, an investor would -Select- (short 1 share of B and 1 share of C, and buy 2 shares of A.short 1 share of B and 1 share of A, and buy 2 shares of C.short 1 share of C and 1 share of A, and buy 2 shares of B.short 2 shares of B and buy 1 share of A and 1 share of C.short 2 shares of A and buy 1 share of B and 1 share of C) a riskless arbitrage investment.

   What is the profit from your investment? Round your answer to the nearest cent.

   $