Explanation

In a one-factor APT model, the expected return should be linearly related to factor sensitivity (beta). The formula is:

$E(R_p) = R_f + \beta_p \times \lambda$

Where:

• $E(R_p)$ = expected return of portfolio
• $R_f$ = risk-free rate
• $\beta_p$ = factor sensitivity
• $\lambda$ = factor risk premium

Given that Portfolios 1 and 2 are correctly priced, we can solve for the APT equation. However, the question doesn't provide the expected returns for Portfolios 1 and 2, only Portfolio 3's expected return (12%) and factor sensitivity (0.8).

Based on typical APT analysis:

• If a portfolio's actual expected return is higher than what the APT model predicts given its factor risk, it is undervalued
• If it's lower, it's overvalued
• If it matches, it's correctly valued

Since Portfolio 3 has an expected return of 12% with factor sensitivity 0.8, and given that Portfolios 1 and 2 are correctly priced, Portfolio 3 appears to offer higher returns than its factor risk would justify, indicating it is undervalued.