Question: 7. Assuming a one-factor model of the form : ; =7% + bF + ei Consider three well diversified portfolios (zero nonfactor risk). The

7. Assuming a one-factor model of the form : ; =7% +

7. Assuming a one-factor model of the form : ; =7% + bF + ei Consider three well diversified portfolios (zero nonfactor risk). The expected value of the factor is 10%. FACTOR MODELS AND ARBITRAGE PRICING THEORY 903 Portfolio Factor Sensitivity Expected Return A 0.75 14.5% B 1.00 15.0% 1.50 22.0% Is one of the portfolio's expected return not in line with the factor model relationship ? Can you construct a combination of the other two portfolios that has the same factor sensitivity as the out of line portfolio ? What is the expected return of the combination ? What action would you expect investors to take with respect to these three portfolios ?

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