QUESTION 7 Consider a two-factor economy. Assets A and B are well-diversified portfolios. The risk-free rate is 1%. The standard deviations of the excess return of factor portfolios 1 and 2 are 18% and 15% respectively. The two factor portfolios are uncorrelated. Asset Beta 1 Beta 2 Forecasted Return A 0.5 1.0 7.00% B 1.0 -0.5 8.00% 1) Assume the market is arbitrage free. What are the risk premiums of factor portfolios 1 and 2? (15 marks) 2) There is a well-diversified portfolio C with beta1=1 and beta2=0.5. It has a forecasted return of 12%. Could you indicate an arbitrage transaction that makes profit? If the answer is yes, justify your answer by explaining how to form the transaction. (15 marks) 3) There is a security with beta1=1 and beta2=0.8. The standard deviation of its excess return is 20%. Calculate the contribution of firm-specific risk to total risk for this security. (10 marks)