Question: Two-factor APT example: Consider the following two-factor model for the returns of three well-diversified assets (i.e., with no idiosyncratic risk): rA = 0.5+2I1 +2I2, rB

Two-factor APT example: Consider the following two-factor model for the returns of three well-diversified assets (i.e., with no idiosyncratic risk):

rA = 0.5+2I1 +2I2,

rB = 0.1I1 +I2

rC = 0.4+I1 I2.

  1. (a)(10 points) Compute the expected return of factor replicating portfolio 1 (FRP1), the expected return of factor replicating portfolio 2 (FRP2), and the risk-free rate.
  2. (b)(5 points) Assume we have a new asset, asset D (also with no idiosyncratic risk), with exposures plus 1 to factor 1 and minus 1 to factor 2. What is its expected return?
  3. (c)(5 points) What is the standard deviation of the return of asset D if both factors have standard deviation of 2%?

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