Problem 1 (40)

Consider the multifactor APT. There are two economic factors. F1 and F2 and they are independent. The risk-free rate of return is 6%. The following information is available about two well-diversified portfolios:

1. We observe a well-diversified portfolio C. Its betas on F1 and F2 are c1=2.0 and c2= 0, and its annual expected return is 16%. Is portfolio C underpriced, or overpriced?
2. If you want to construct a risk-free arbitrage strategy to exploit the mispricing in part (B), you need to short sell a hedging portfolio. How will you construct the hedging portfolio using portfolios A, B, and the risk-free asset? (Write down the weights)

Factor Sensitivity for F1 BA1 = +1.0 BB1 = +2.0 Portfolio A Portfolio B Factor Sensitivity for F2 = +2.0 BB2 = +2.0 BA2 Annual Expected Return 19% 22% Assume portfolios A and B are efficiently priced. Please answer following questions. Factor Sensitivity for F1 BA1 = +1.0 BB1 = +2.0 Portfolio A Portfolio B Factor Sensitivity for F2 = +2.0 BB2 = +2.0 BA2 Annual Expected Return 19% 22% Assume portfolios A and B are efficiently priced. Please answer following questions