Suppose that asset returns in the economy are described by the following two-factor model:

Portfolio A
B
C

Expected Return E( Ri ) bi,1 bi,2 15% 1.0 0.6 14% 0.5 1.0 10% 0.3 0.2

= + , + , + ,

where , , and , are asset-specific constants. Furthermore assume that the have zero mean, [ ] = 0 , and are uncorrelated across assets, = 0 for 1 . Furthermore, assume that the factors satisfy [] = [] = 0, and [] = 0. Suppose there exist three well-diversified portfolios A, B, and C with the following characteristics:

a) Find the Factor Risk Premia 1 and 2.

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.