Random returns for two well–diversified portfolios at time t are given by:
rAt= 0:27 + 2F1t+ 0:8F2t
rBt= 0:161 +F1t+ 1:1F2t;
Where F1and F2 are unexpected parts of factor 1 and 2 returns, respectively. (One can think that factor one is GDP and factor two is 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 question for 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