Problem . Assume that the following two-index model describes returns: E[ri]=rf+bi11+bi22 Assume that the following portfolios are observed: 1. According to APT, what is the expected return, factor-loading relationship for this market (do not consider D for this part)? Hint: Use the first three assets to set up a system of linear equations implied by the two-index model. Then solve for the unknown parameters (rf,1,2) and write down a formula for the expected returns of assets as a function of bi,k. 2. Now consider portfolio D with the characteristics from the table above. Is an arbitrage opportunity possible? If yes, then describe the arbitrage opportumity, i.e. construct an arbitrage portfolio. Hint: Use the pricing equation calculated in part 1. to compare the model implied expected return with the actual expected return. A potential arbitrage opportunity would have the same factor loadings as D but a different expected return. Solution 1 Same idea as before, except that you need to solve rf also. 1=2%2=9%rf=2% 2 rf+31+22=26%