Question 7: Suppose that asset returns in the economy are described by the following two-factor model: R = a, + b +b;2Fz+e, where ai, biji and bi,2 are asset-specific constants. Furthermore assume that the e have zero mean, El ei ) = 0, and are uncorrelated across assets, El exej ) = 0 for i tj. Suppose there exist three well- diversified portfolios A, B, and C with the following characteristics: Portfolio Expected Return E(R) bul bi2 A 15% 1.0 0.6 B 14% 0.5 1.0 10% 0.3 0.2 a) Find the Factor Risk Premia 21 and 22. b) Assume portfolio E has expected return 15% and factor loadings be,1 = be,2= 0.6. Find a combination of portfolios A, B, and C (call this portfolio D) that has the same systematic risk as portfolio E. c) Find the expected return on portfolio D. d) Is there an arbitrage opportunity in this market? If so, construct an arbitrage strategy using only portfolios D and E