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    well- diversified balanced Portfolio P, which has an Investor Sentiment factor sensitivity equal to 1.25 and a Business Cycle factor sensitivity equal to 1.10. According to Driver Associates's Arbitrage Pricing Model, the expected return for Portfolio P equals:
    A. 8.3%.
    B. 13.3%.
    C. 10.8%.
    Answer: B
    Explanation:
    Explanation/Reference:
    Explanation:
    According to the Arbitrage Pricing Model, the expected return equals: risk free rate + R + b2RP2 where R is the risk premium for factor i. Portfolio D is designed to have sensitivity equal to one to the investor sentiment risk factor and sensitivity equal to zero to the business cycle risk factor. Similarly, Portfolio E is a portfolio designed to have sensitivity equal to zero to the investor sentiment risk factor and sensitivity equal to one to the business cycle risk factor. Portfolios that have a sensitivity equal to 1.0 to one factor and zero sensitivity to the remaining factors are called "factor portfolios." Therefore, Portfolio D is the investor sentiment factor portfolio and Portfolio E is the business cycle factor portfolio. According to the multifactor equations, the expected return (intercept) for the investor sentiment factor portfolio (D) equals 9% and for the business cycle factor portfolio (E) equals 8%. Risk premiums are defined as the difference between the expected return on the appropriate factor portfolio and the risk-free rate. The risk-free rate is 5% (the long- term government bond yield). Therefore, the investor sentiment risk premium equals 0.09 - 0.05 = 0.04.
    Similarly, the business cycle risk premium equals 0.08 - 0.05 = 0.03. Therefore, the expected return for Portfolio P equals 0.05 + 1.25(0.04) + 1.1(0.03) = 13.3%. (Study Session 18, LOS 64.1)

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