Problem 2:

You have done some analysis to estimate the factor sensitivities (or "loadings") of the following well-diversified portfolios (A, B, and C) to two "factor" portfolios (F1 and F2) that you think cover most of the important risks in the economy.You have also estimated the expected returns for these stocks.

Fund Expected ReturnFactor Loading for F1 Factor Loading for F2

A.15 0.60.9

B.221.60.5

C.150.80.7

Risk-free rate .030.00.0

Questions:

1. Based solely on A and C, what set of factor risk premia (one for F1 and another for F2) explain the expected returns of A and C?

1. Given your answer to (i) above, what would you predict the expected return on B to be?Is there a difference between what is in the table above for B and your answer based on A and C?If so, is there an arbitrage opportunity (just answer yes or no)?

E(R_B) = _______________

Difference: (circle one)Yes No

Arbitrage Opportunity:(circle one)YesNo

Briefly explain why:

1. If there is an arbitrage opportunity with A, B, C, and risk-free borrowing or lending given the estimates in the table above, how would you exploit it?Be explicit about what and how much you should buy and what and how much you should sell.(7 points)