1. Consider a two-factor economy. The riskfree rate is 2%. There are two well-diversified risky assets with the following information. Assume the market is arbitrage free.

(1)What are the risk premiums of factor portfolio 1 and 2? (15 marks)

(2)A well-diversified risky asset has1= 1.2and2= 0.8. What is its arbitrage-free

expected return? (10 marks)

(3)If the forecasted return of asset in (2) is 18%. Indicate an arbitrage transaction that could

be used to profit from this pricing situation.