Suppose we have 3 widely diversified portfolios with the following data:

Portfolio Expected Return bi1 bi2

A 15 1 0.6

B 14 0.5 1

C 10 0.3 0.2

Further, suppose that the expected return of combinations of these portfolios can be solved for given the following equation:

Expected Portfolio Return = 7.75 + 5bi1 + 3.75bi2

Now, suppose we construct a portfolio E with an expected return of 15%, a bi1 of 0.6 and a bi2 of 0.6.

Compare this with a portfolio D constructed by placing 1/3 of the funds in A, 1/3 in B, and 1/3 in C.

What is the expected return and risk of D versus E? How can an investor use arbitrage to exploit the return and risk differences between D and E? Finally, how does all of this contribute to the equilibrium model produced by the arbitrage pricing model (APT) when returns are generated by a two index model?