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Consider a market where two factors are sufficient to describe the returns on common stocks.

Consider a market where two factors are sufficient to describe the returns on common stocks. For
an asset i, the asset’s expected return is given by E(ri) = rf + bi1 P1 + bi2 P2, where P1 and P2 are the
factor premiums (expected return of the factors in excess of the risk-free rate). Both factors are
independent. The following table gives the sensitivities of the stocks ABC and PQR to the two
factors, as well as the expected returns of each stock:
Security bi1 bi2 E[ri]
ABC 0.6 0.9 18.3
PQR 1.7 1.3 20.2
Riskless 0.0 0.0 5.0
.a) Consider a portfolio, C, made up by selling short $.40 of security PQR and purchasing $1.40 of
ABC. How sensitive will this portfolio be to each of the two factors P1 and P2?

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