1. The APT itself does not provide guidance concerning the factors that one might expect to determine risk premiums. How should researchers decide which factors to investigate? Why, for example, is industrial production a reasonable factor to test for a risk premium? (30 Points)

2. If the APT is to be a useful theory, the number of systematic factors in the economy must be small. Why? (20 Points)

3. As a finance intern at Pork Products, Jennifer Wainwright's assignment is to come up with fresh insights concerning the firm's cost of capital. She decides that this would be a good opportunity to try out the new material on the APT that she learned last semester. She decides that three promising factors would be (a) the return on a broad-based index such as the S&P 500; (b) the level of interest rates, as represented by the yield to maturity on 10-year Treasury bonds; and (c) the price of hogs, which is particularly important to her firm. Her plan is to find the beta of Pork Products against each of these factors by using multiple regression and to estimate the risk premium associated with each exposure factor. Comment on Jennifer's choice of factors. Which are most promising with respect to the likely impact on her firm's cost of capital? Can you suggest improvements to her specification?