SELF TEST 10 Assume a market with two market factors F1, and F2 that have zero expectation and zero covariance. The return of an individual security, i, at any given point of time t, Ri,t in this market is generated by a two-factor model. There are four securities in thic market that have the following characteristics: Where 1 and p2 are une respective betas (risk indicators) for the two factors Further, the market is assumed to be perfect with possibility of short sales and no transaction costs. Provide your response to each of the following requirements: (a) Each of two Investors, X and Y, is interested in creating a portfolio containing (long or short) two of these securities with a return that does not depend on the market factor, F1,t, in any way - that is, factor F1,t has zero effect on the portfolio beta. Investor X is considering securities A and B while Investor Y is considering securities C and D. (i) Construct the portfolio for investor X and compute the portfolio's expected return (Rp,t) and the beta coefficient (p) (ii) Construct the portfolio for investor Y and compute the portfolio's expected return (Rp,t) and the beta coefficient (p) (iii) Comment on the risk and return of the portfolio and if you find them consistent with the risk return trade-off notion. (b) Suppose the risk-free asset in market has expected return equal to 5 percent, 1 =0 and 2=0. Does the market present arbitrage opportunity to any of the two investors? If yes, explain, in details, the strategy that the investor should implement to exploit the arbitrage opportunity. (c) What effect would the existence of any arbitrage opportunities have on the capital markets for these securities in the short and long run