Problem #3:

Below is the information for Example 3 in notes N9 on page 21.This table indicates the expected returns (E(r)) and the factor sensitivities (denoted Beta1 and Beta2) for two factors for four portfolios.

Beta1Beta2E(r)

Port A 1.5.6.20

Port B .5.5.095

Port C0 0 .02

Port D.21.0.13

Questions:

a.What factor risk premia are consistent with APT for the first three portfolios?

b.Given these factor risk premia, Is the expected return for Portfolio D in the table consistent with the factor risk premia implied by portfolios A, B, and C?

c.If your answer to b is "no," then there is an arbitrage opportunity (that is, the four portfolios are not priced consistently relative to each other). If your answer to be b is "no," how might you exploit the relative mispricing of these portfolios?