a) In this we are required to calculate the values of F i.e.

unanticipated risk:

Considering the growth factor :( 1/3*0%) + (1/3*5%) +(1/3*10%)

= 0+.017+ .033 = 5%

Now the unanticipated risk for each situation can be calculated as follows:

F (ugly) = 0% - 5% = -5%

F (bad) = 5% - 5% = 0%

F (good) = 10%-5% = 5%

b) In this we need to calculate the return on asset and the factor sensitivity:

Stock A, bad state can be used to calculate the expected return:

The formula for asset return is: RA = E (ri) + βi (F) + e

0.06 = E (ri) + βi * 0% => E (ri) = 0.06

Factor sensitivity: for ugly state: 0.16 = 0.06 + β i*-5% => βi = -2%

For good state: - 0.04 = 0.06 + β i * 5% => βi = -2%

Stock B, bad state can be used to calculate the expected return:

The formula for asset return is: RA = E (ri) + βi (F) + e

0.09 = E (ri) + βi * 0% => E (ri) = 0.09

Factor sensitivity: for ugly state: 0.04 = 0.09 + β i*-5% => βi = 1%

For good state: 0.14 = 0.09 + β i * 5% => βi = 1%

Stock C, bad state can be used to calculate the expected return:

The formula for asset return is: RA = E (ri) + βi (F) + e

0.12 = E (ri) + βi * 0% => E (ri) = 0.12

Factor sensitivity: for ugly state: 0.02 = 0.12 + β i*-5% => βi = 2%

For good state: 0.22 = 0.12 + β i * 5% => βi = 2%

c) In this we are required to calculate the risk-free rate and factor premium. This can be done using
CAPM model:

E (ri) = Rf+ β*risk premium

Taking only 2 securities i.e. A and B

Stock A, E (ri) = 0.06, β = -0.02 also the risk premium is 1.

Therefore, risk free rate: E (ri) = Rf + β * risk premium => 0.06 = Rf + -0.02*1

Rf = 0.08

Stock B, E (ri) = 0.09, β = 0.01 also the risk premium is 1.

Therefore, risk free rate: E (ri) = Rf + β * risk premium => 0.09 = Rf + 0.01*1

Rf = 0.08

Therefore, the risk free rate is 8% and factor premium is 1.

d) In this we are required to calculate the risk-free rate and factor premium. This can be done using
CAPM model:

E (ri) = Rf+ β*risk premium

Taking only 2 securities i.e. A and C

Stock A, E (ri) = 0.06, β = -0.02 also the risk premium is 1.5

Therefore, risk free rate: E (ri) = Rf + β * risk premium => 0.06 = Rf + -0.02*(1.5)

Rf = 0.09

Stock C, E (ri) = 0.12, β = 0.02 also the risk premium is 1.5

Therefore, risk free rate: E (ri) = Rf + β * risk premium => 0.12 = Rf + 0.02*1.5

Rf = 0.09

Therefore, the risk free rate is 9% and factor premium is 1.5

e) Comparing the results of c and d in the problem given, we can say that there is an arbitrage
opportunity for the investor.