1 You are using a two factor APT model to find the fair expected return on a well diversified portfolio P that promises an actual expected return of 18 The relevant factor portfolios, their betas in portfolio P, and their factor risk premia are shown in the table below The risk free rate is 2 5 Factor Factor Beta Factor risk premium A 1 2 12 B 0 8 3 5 a) According to the APT, what is the fair expected return on the portfolio P b) Suppose there exists an additional portfolio Q, which has a beta of 1 on each factor and an expected return of 15 875 Assuming the risk premium on Factor A is estimated correctly, what must the risk premium on Factor B be to exclude arbitrage opportunities between P and Q

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Question: 1. You are using a two-factor APT model to find the fair expected return on a well-diversified portfolio P that promises an actual expected return

1. You are using a two-factor APT model to find the fair expected return on a well-diversified portfolio P that promises an actual expected return of 18%. The relevant factor portfolios, their betas in portfolio P, and their factor risk premia are shown in the table below. The risk-free rate is 2.5%.

Factor	Factor Beta	Factor risk premium
A	1.2	12%
B	0.8	-3.5%

a) According to the APT, what is the fair expected return on the portfolio P?

b) Suppose there exists an additional portfolio Q, which has a beta of 1 on each factor and an expected return of 15.875%. Assuming the risk premium on Factor A is estimated correctly, what must the risk premium on Factor B be to exclude arbitrage opportunities between P and Q?

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