Ms. Bethel, manager of the Humongous Mutual Fund, knows that her fund currently is well diversified and that it has a CAPM beta of 1.0. The risk-free rate is 8% and the CAPM risk premium, [E(R,„) - RA, is 6.2%. She has been learning about APT measures of risk and knows that there are (at least) two factors: changes in the industrial production index, ,51, and unexpected inflation, 52. The APT equation is
a) If her portfolio currently has a sensitivity to the first factor of bp, = - .5, what is its sensitivity to unexpected inflation?
b) If she rebalances her portfolio to keep the same expected return but reduce her exposure to inflation to zero (i.e., bp2 = 0), what will its sensitivity to the first factor become?