Tutorial Solutions

As part of efforts to provide feedback on your learning progress, I provide an indicative difficulty
level of questions, measured as the passing rate (e.g., easy questions have higher passing rates).
This is based on the students’ performance in the previous years. For example, a level “B” multiple
choice question means about 70% students passed this question; a level “B” problem solving
question means on average students got about 70% of total marks. You can use it to assess your
performance.
Keep in mind that questions in the Problem Set are highly selective, so the Problem Set on average
is more difficult than the final exam paper.

Difficulty level Passing rate Indicator

Easy >80% A
Moderate 60 – 80% B
Difficult 40 – 60% C
Very difficult 25 – 40% D
Extremely difficult <25% E

1. Consider the single factor APT. Portfolio A has a beta of 0.2 and an expected return of 13%.
Portfolio B has a beta of 0.4 and an expected return of 15%. The risk-free rate of return is 10%.
If you wanted to take advantage of an arbitrage opportunity, you should take a short position in
portfolio __________ and a long position in portfolio _________.

A. A; A
B. A; B
C. B; A
D. B; B
Difficulty level: C

Answer: C

Consider risk premium per unit of systematic risk.

A: (13%-10%)/0.2 = 0.15
B: (15%-10%)/0.4 = 0.125, which is less than that of A.
So, buy A and Short B.

2. Consider the single factor APT. Portfolio A has a beta of 1.3 and an expected return of 21%.
Portfolio B has a beta of 0.7 and an expected return of 17%. The risk-free rate of return is 8%. If
you wanted to take advantage of an arbitrage opportunity, you should take a short position in
portfolio __________ and a long position in portfolio _________. Show your calculations.
 Difficulty level: C

3. Is it possible that the Arbitrage Pricing Theory (APT) is valid while the Capital Asset Pricing
Model (CAPM) is not?
Difficulty level: B

Yes. The APT may exist without the CAPM, but not the other way. The reason being, that the APT
accepts the principle of risk and return, which is central to CAPM, without making any
assumptions regarding individual investors and their portfolios. These assumptions are necessary
to CAPM.

4. How is the APT model different from the CAPM model?

A. The APT model is derived from the Capital Market Line.

B. The CAPM is derived from the Security Market Line.
C. In the APT model, there is no need for a risk factor to be the market portfolio.
D. All of the above.
E. None of the above.
Difficulty level: B

Answer: (C)
In the CAPM, the risk factor has to be the market portfolio; no such assumption in the APT Model.

5. In the APT framework, which of the following conditions could be true in order to correctly
form an arbitrage strategy (zero-net investment strategy):

[I] The arbitrage portfolio is risk free, so it has a return of the risk-free rate.
[II] The arbitrage portfolio must have zero systematic risk.
[III] The arbitrage strategy must have zero idiosyncratic risk.

A. I only
B. I and II only
 C. II only
D. II and III only
E. I, II, and III
Difficulty level: B

Answer: (D)
I. The arbitrage portfolio has no risk of loss but this doesn’t mean its return = the risk-free rate.
II and III: The arbitrage portfolio has zero exposure to the systematic (idiosyncratic) risk.
Otherwise, it could have negative payoffs in the future.

6. Arbitrage is __________________________.

A. betting on high beta assets to get high returns

B. the creation of riskless profits made possible by relative mispricing among securities
C. a common opportunity in modern markets
D. an example of a risky trading strategy based on market forecasting
Difficulty level: B

Answer: (B)

7. There is a single MARKET risk factor in the economy. In the table below, all Portfolios are
well diversified portfolios and the risk-free rate is 3%. Given the table below, is there an
arbitrage opportunity?

Portfolio E(R) Market BETA

ABC 9% 2
XYZ 8% 1.5
Market 6% 1

A. Yes, ABC is underpriced.

B. Yes, ABC is overpriced
C. Yes, XYZ is underpriced
D. Yes, XYZ is overpriced.
E. Not enough information provided.
Difficulty level: C

Answer: C

No-Arb Expected Return ABC = 3+(6-3)(2)=9% (ABC is fairly priced)

No-Arb Expected Return XYZ = 3+(6-3)(1.5)=7.5% (XYZ is under priced)
8. The table below provides factor risk loadings and factor risk premia for a two factor model for
a particular portfolio where factor portfolio 1 tracks GDP and factor portfolio 2, IR, tracks
unexpected changes in interest rates. The risk-free rate RF is 5%.

Portfolio Factor Loading Risk Factor Risk Premium

ABC Portfolio
βGDP 0.7 GDP 8%
βIR -1.5 IR 2%

Compute the expected excess return of the portfolio.

A. 1%
B. 2.5%
C. 6%
D. 7.6%
E. None of the above
Difficulty level: B

Answer: E
Expected Excess Return = 0.7(8%)+(-1.5)(2%) = 2.6%

9. Suppose the TRUE model of expected returns is the Fama-French 3-factor model. For a
particular security, you estimate its alpha and beta using the CAPM model. Which of the
following could be true?

A. You find a positive alpha.

B. You find a negative alpha.
C. You find a zero alpha.
D. All of the above are possible.
Difficulty level: C

Answer: D
If the Fama-French 3-factor is the correct model, e.g.,

then when using CAPM, you will see CAPM’s alpha = .

Depending on the values, CAPM’s alpha could be positive, negative, or zero (for example, if
both beta_SMB and beta_HML are zero).
10. Assume that both X and Y are well diversified portfolios and the risk-free rate is 8%.

Difficulty level: C

Answer: b.
rf = 8% and E(rM) = 16% (from X)
E(rY) = rf + 𝛽 [E(rM) – rf] = 8% + 0.25 *(16% - 8%) = 10%, which is less than 12%.
Therefore, there is an arbitrage opportunity.

11.

Difficulty level: D

Answer: c.
Positive alpha investment opportunities will quickly disappear, because once such opportunity is
observed, the arbitrageurs will take the large position in it, and therefore push the price back to
equillibirum.
d is incorrect: investors will pursue arbitrage opportunites, independent of her risk aversion.
12.

Difficulty level: B

Answer: c.
Investors will take on as large a position as possible only if the mispricing opportunity is an
arbitrage, which is risk free. Otherwise, considerations of risk and diversification will limit the
position they attempt to take.

13. Suppose A and B are two stocks, C is a well diversified portfolio. The annualized risk and
return information of these assets is provided in the following table. You also know that the
correlation coefficient between A and B is negative 1.

Expected Return Standard Beta against

(ER) deviation (Std) market index
A 10% 14%
B 4% 7%
C 11.9% 0.6

(a) Please construct a risk-free portfolio (Q) with assets A and B only. What is the expected return
of Q?
(b) If the only risk factor in the economy is the market portfolio (M) which has an expected return
of 12.5%, please construct a risk-free portfolio (P), using assets M and C only. What is the
return of P?
(c) Is there any riskless arbitrage opportunity among assets A, B, C, and the market portfolio M?
If your answer is yes, please describe the complete arbitrage portfolio and the transactions
involved. Show your calculation.
Difficulty level: E

Answer:

(a)
Combine A and B to form a fully diversified (risk free) portfolio.
If ρ= -1, σAB= |WAσA - WBσB|=0; Therefore: WA*14% -(1- WA)*7%=0; WA=1/3 and WB=2/3
ERQ = 1/3*10% + 2/3*4%= 6%.
Therefore, we have a risk-free asset Q that offers an expected return of 6% and std of 0.

(b) Let's form a portfolio P between portfolio C and the market portfolio M so that the beta=0.
Wc*0.6+(1- Wc)*1=0; Wc=2.5 and WM=-1.5
The expected return of P is ERp = 2.5*11.9% - 1.5*12.5%=11%. Note P is risk free.

(c) Therefore, You should long portfolio P (long C and short M) and short Q (short A and short
B). You will achieve a risk free return of 11%-6%=5%.

Arbitrage will stop when return per unit of systematic risk is the same for all assets. Portfolio C's
expected return will drop, M's expected return will rise, and expected returns on both A and B
will likely rise too. That, the price of C will increase, the prices of M, A, and B will drop, during
arbitrage trading.

14.

Difficulty level: E

Answer:

Since the beta for Portfolio F is zero, the expected return for Portfolio F equals the
risk-free rate.

For Portfolio A, the ratio of risk premium to beta is: (10 - 4)/1 = 6
The ratio for Portfolio E is higher: (9 - 4)/(2/3) = 7.5

This implies that an arbitrage opportunity exists. For instance, by taking a long position
in Portfolio E and a short position in Portfolio F (that is, borrowing at the risk-free rate
and investing the proceeds in Portfolio E), we can create another portfolio which has the
same beta (1.0) but higher expected return than Portfolio A. For the beta of the new
portfolio to equal 1.0, the proportion (w) of funds invested in E must be: 3/2 = 1.5.
 Contribution to Excess
Portfolio Weight In Asset Contribution to β Return
-1 Portfolio A -1 x βA = -1.0 -1.0 x (10%- 4%) = -6%
1.5 Portfolio E 1.5 x βE = 1.0 1.5 x (9% - 4%) = 7.5%
-0.5 Portfolio F -0.5 x 0 = 0 0
Investment = 0 βArbitrage = 0 α = 1.5%

As summarized above, taking a short position in portfolio A and a long position in the
new portfolio, we produce an arbitrage portfolio with zero investment (all proceeds from
the short sale of Portfolio A are invested in the new portfolio), zero risk (because 
and the portfolios are well diversified), and a positive return of 1.5%.

15. Suppose there are three well diversified portfolios, A, B, and C, in the market. Portfolio A has
a beta of 1.5 and an alpha of 2% per year when regressed against a systematic factor M. Portfolio
B has a beta of 0.5 and an alpha of 1% per year. Portfolio C has a beta of -0.5 and an alpha of 1%
per year.

(a) Using assets A and B to construct a new portfolio Z which has a beta of -0.5. What is the
portfolio Z’s alpha?

(b) Is there a riskless arbitrage opportunity? If your answer is yes, please describe a complete
arbitrage portfolio which invests $100 in portfolio C. What’s the arbitrage profit in this case?

Difficulty level: E

Answer:
(a) WA=-1, WB=2
Alpha of Z is -1*2%+2*1%=0.
Z takes a short position of A and a long position of B.
(b) Yes, there is a riskless arbitrage opportunity. Both Z and portfolio C have the same beta of
-0.5, but C has a higher alpha. An arbitrager can long C and short Z.
Note that Short Z = Long A + Short B.
A complete portfolio = Invest $100 in C + Short $100 in Z
= Invest $100 in C + Long $100 in A + Short $200 in B
One year later, you make $1.
Note that the prices of C and A would increase while the price of B will decrease, due to arbitrage
trading, which restores the market equilibrium.