Question

1) Consider the single factor APT. Portfolio A has a beta of 1.7 and an expected return of 19%. Portfolio B has a beta of .6 and an expected return of 15%. The risk-free rate of return is 11%. If you wanted to take advantage of an arbitrage opportunity, you should take a short position in portfolio __________ and a long position in portfolio

Answer 1

A, B.

Step-by-step explanation:

E(r) = Rf + beta (Risk premium on factor)

PORTFOLIO A

19% = 11% + 1.7(RP)

19% - 11% = 1.7(RP)

(RP) = 0.08/1.7

(RP) = 0.047059

(RP) = 4.706%

PORTFOLIO B

15% = 11% + 0.6(RP)

15% - 11% = 0.6(RP)

(RP) = 0.04/0.6

(RP) = 0.06667

(RP) = 6.667%

As risk premium is lower in case of portfolio A, the correct strategy is Short Position in Portfolio A and Long Position in Portfolio B