Consider the single factor APT. Portfolio A has a beta of 0.5 and an expected return of 12%. Portfolio B has a beta of 0.4 and an expected return of 13%. The risk-free rate of return is 5%. 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

Question

Quizplus · Accepted Answer

To exploit an arbitrage opportunity, you should short the overpriced asset and go long on the underpriced one. According to the Capital Asset Pricing Model (CAPM), which is a simplified version of the Arbitrage Pricing Theory (APT) for this context, the expected return of a portfolio should equal the risk-free rate plus the portfolio's beta times the market risk premium. Portfolio A's expected return is lower than it should be for its beta (indicating it is overpriced), and Portfolio B's expected return is higher than it should be for its beta (indicating it is underpriced). Therefore, you should short Portfolio A and go long on Portfolio B.

Consider the Single Factor APT