Use the information in the following table to answer questions 9 12. Assume a one-factor APT world. You have identified the expected returns and sensitivities for the following three large portfolios.

Using Excel, graph the 3 securities in expected return - sensitivity space. Based on your graph,

a. Which security is relatively underpriced?

b. Which security is relatively overpriced?

10. In a perfectly competitive market, the above risks and returns cannot exist for long. Describe the forces that bring about equilibrium.

11. What three conditions define an arbitrage portfolio?

Security Sensitivity (b) Expected return Tor E[r] 5% 7% 16% 0.0 0.9 1.5 12. Suppose that the weights comprising a portfolio are XA =0.2, X3 =-0.5, and Xc =0.3. Demonstrate that this portfolio is, in fact, an arbitrage portfolio. (Hint: describe mathematically the three conditions of an arbitrage portfolio.)