1 Question 1. Suppose that a two-factor model, where the factors are the stock market (Factor 1) and the growth rate of industrial production (Factor 2), correctly describes the return generating processes of all assets and the corresponding two-factor APT correctly prices three well-diversified portfolios, A, B, and C. Portfolio A B Expected Return Sensitivity to Factor 1 Sensitivity to Factor 2. 19% 2 0 8% -1 2 5% 0 0 a. What are i) the risk premiums of the two factors and ii) the risk-free rate? (4 marks) b. Another well-diversified portfolio D has sensitivities 0 and 1 to factor 1 and factor 2, respectively. What is the APT-consistent expected return on Portfolio D? (2 marks) C. Suppose that Portfolio D's expected return is 8%. Given your answers above, design an arbitrage strategy involving Portfolios A, B, C, and D. (Hint: an arbitrage strategy requires no initial investment, has no risk and yet generates a positive return.) (4 marks) (Total for Question: 10 marks)