Question: Arbitrage Pricing Theory Please show your work. You estimate a 2-factor return-generating process for 4 large portfolios with the following results. r A = 4

Arbitrage Pricing Theory

Please show your work.

You estimate a 2-factor return-generating process for 4 large portfolios with the following results.

rA = 4 + 1.2 F1 + 0.5F2

rB = 1 + 0.8F1 - 0.5F2

rC = 6 - 1.2F1 + 0.5F2

rD = 2 + 1.2F1 + 0.5F2

QUESTIONS:

(1) Which 2 portfolios are functional equivalents according to the Arbitrage Pricing Theory?

(2) Suppose you are in the APT world and:

0 = 3%,

1 = 6% and

2 = 8%.

What is the expected return on portfolio D?

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