Q

Random returns for two welldiversified portfolios at time t are given by:

rAt= 0:27 + 2F1t+ 0:8F2t rBt= 0:161 +F1t+ 1:1F2t; where F1and F2 are unexpected parts of factor 1 and 2 returns, respectively. (One can think that factor one is GDP and factor two is an inflation). The risk free rate is 1:0%. a. Construct factor portfolio for factor 1 by combining portfolios A, B, and T-bills.What are the weights of these portfolios in factor portfolio 1? What is the expected return of factor portfolio 1? b. Solve questionafor factor portfolio 2 c. Assume that the market does not allow arbitrage strategies and so the twofactor APT holds. Find the expected returns on portfolio C which betas with respect to factors 1 and 2 are 0.5 and 1.2, respectively