Consider the following single factor APT model, rP = 0.04 + 0.08P . The risk premium on a portfolio with unit sensitivity is 8%. The risk-free rate is 4%. You have uncovered three well-diversified portfolios with the following characteristics.

Portfolio Expected Return RP

A 0.104 0.8

B 0.100 1.0

C 0.136 1.2

a) Which of these portfolios is not in line with the APT?

(10 Marks)

b) Suppose you cannot lend or borrow at the risk-free rate. How would you exploit arbitrage opportunity using the three portfolios above? What is the profit?

(20 Marks)

c) Now consider you can trade the risk-free asset and there are no short-selling constraints. How would you exploit the arbitrage opportunity using the three

portfolios above? What is the profit?

(20 Marks)