5. In a market in which the Arbitrage Pricing Theory (APT) model holds, the expected return is given by E[Ri] = 10 + Bi,121 + B1,212+, ..., +Binin a) Define all the terms in the above expression and explain what the expression conveys. [2 marks] b) Explain what you understand by a risk-free portfolio in the context of APT. Discuss the expected return of a risk-free portfolio using the APT expression. [2 marks] c) Assume that risk-free rate in this economy is 0.02. Consider a two-factor model, n = 2 and two well diversified portfolios P1 and P2 with the following features: Expected returns: E(R;) Sensitivity to factor 1: Bi,1 Sensitivity to factor 2: Biz P1 0.18 0.2 0.7 P2 0.05 0.1 0.3 Find the risk premiums for each factor. [4 marks] d) Assume there is another well diversified security Pz in this economy with factor sensitivities, B3,1 = 0.2, and $3,2 = 0.7. The expected return of this security is E(R3) = 0.25. State whether the APT is satisfied. If yes, explain why, if not propose an arbitrage strategy [3 marks] [Total: 11 marks]