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QUESTION 12 Assume that the single index model holds for all securities and an investor comes up with the following equation for the return of the well diversified portfolio P: rp = 16% +0.5Rm where Rm is an excess return on the market. The risk-free rate is 2% and the market expected return is 10%. (Tips: Rules on expectation: E(a) =a; E(x + a) = E(x) + a; where a is a constant) a. Does APT hold for portfolio P? (4 pts) b. Does an arbitrage opportunity exist in this economy? If so, what would be an arbitrage strategy? (8 pts) c. Now suppose that portfolio P is not well-diversified so that: rp=16% +0.5Rm +ep where ep is unexpected contribution from portfolio specific risk to the return of P. Does an arbitrage opportunity exist? Why? If yes, what is an arbitrage strategy? (2 pts) QUESTION 12 Assume that the single index model holds for all securities and an investor comes up with the following equation for the return of the well diversified portfolio P: rp = 16% +0.5Rm where Rm is an excess return on the market. The risk-free rate is 2% and the market expected return is 10%. (Tips: Rules on expectation: E(a) =a; E(x + a) = E(x) + a; where a is a constant) a. Does APT hold for portfolio P? (4 pts) b. Does an arbitrage opportunity exist in this economy? If so, what would be an arbitrage strategy? (8 pts) c. Now suppose that portfolio P is not well-diversified so that: rp=16% +0.5Rm +ep where ep is unexpected contribution from portfolio specific risk to the return of P. Does an arbitrage opportunity exist? Why? If yes, what is an arbitrage strategy? (2 pts)

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