Question: B4. [1+3=4 marks] You are using a two-factor APT model to find the fair expected return on a well-diversified portfolio P that promises an actual

B4. [1+3=4 marks] You are using a two-factor APT model to

B4. [1+3=4 marks] 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 12.00% -3.50% B 0.8 a) According to the APT, what is the "fair" expected return on the portfolio P? [1 mark] 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? [3 marks]

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