You have a well-diversified portfolio P. You believe that the return of P is exposed to 3 systematic risk factors, market risk (M) and exchange rate risk (X) and Inflation risk (I). The sensitivity of Ps return to M is 1.2, to X is 0.7 and to I is 0.5. You have estimated the expected excess return of portfolios that mimic these 3 risk factors are 7%, 3% and 2% respectively.

Assume there is a portfolio, PM, that mimics Factor M, there is a portfolio, PX, that mimics factor X and there is a portfolio PI that mimics factor I. Below is the sensitivity of these 3 portfolios to 3 factors. Calculate the excepted excess returns of these 3 portfolios if they are correctly priced based on APT.

portfolio	Sensitivity to factor M	Sensitivity to factor X	Sensitivity to factor I
PM	1	0	0
PX	0	1	0
PI	0	0	1

Combine these 4 portfolios, P, PM, PX and PI and the risk-free asset with the following weights and make portfolio A. w(p) = 1, w(PM) =-1.2, w(PX) = -0.7 and w(PI) = -0.5 and w(rf) = 1.4. How much is the expected excess return of portfolio A?

What is the sensitivity of A to each factor?

Is A an arbitrage portfolio? Recall that an arbitrage portfolio has 2 characteristics. Using A, explain why portfolio P cannot have 12% return?