Explanation:
For XENA, $19% = 1.7F + 8%F = 6.47%15`% = 2.2F + 8%F = 3.18%$
The single factor APT implies a higher expected return for XENA versus YNN, so XENA is underpriced and a buy opportunity. On the other hand, YNN is overpriced so shorting YNN and investing proceeds to XENA produces arbitrage profit as the factor (market premium assumed) is realized over time.
Thus, short YNN and take a long position in XENA.
Shorting stocks with positive expected values above the risk-free rate and taking a long position in the risk-free rate is not a viable option in this case.
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Q.57 Consider a single factor APT in a country where the risk-free rate is 8%. The stocks of XENA have a beta of 1.7 and an expected return of 19%. The stocks of YNN have a beta of 2.2 and an expected return of 15%. Assuming you wanted to exploit an arbitrage opportunity, you would take a short position in:
A
YNN and use the proceeds to take a long position in XENA
B
XENA and use the proceeds to take a long position in YNN
C
YNN and use the proceeds to take a long position in the riskless asset
D
XENA and use the proceeds to take a long position in the riskless asset
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