Question: Random returns for two well-diversified portfolios at timetare given by: rAt= 0.27 + 2F1t+ 0.8F2t rBt= 0.161 +F1t+ 1.1F2t, whereF1andF2are unexpected parts of factor 1

Random returns for two well-diversified portfolios at timetare given by:

rAt= 0.27 + 2F1t+ 0.8F2t

rBt= 0.161 +F1t+ 1.1F2t,

whereF1andF2are unexpected parts of factor 1 and 2 returns, respectively. (One can think that factor one is GDP and factor two is an inflation). The risk free rate is 1.0%.

a. Construct factor portfolio for factor 1 by combining portfolios A, B, and T-bills. What are the weights of these portfolios in factor portfolio 1? What is the expected return of factor portfolio 1?

b. Solve questionafor factor portfolio 2

c. Assume that the market does not allow arbitrage strategies and so the two- factor APT holds. Find the expected returns on portfolio C which betas with respect to factors 1 and 2 are 0.5 and 1.2, respectively.

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