the capital asset pricing model, arbitrage pricing theory: a. Requires that markets be in equilibrium. b. Uses risk premiums based on micro variables. c. Specifies the number and identifies specific factors that determine expected returns. d. Does not require the restrictive assumptions concerning the market portfolio. III. Equilibrium In Capital Markets 11. Arbitrage Pricing Theory The McGraw−Hill Companies, 2001           CHAPTER 11 Arbitrage Pricing Theory 339       SOLUTIONS TO CONCEPT C H E C K S 1. The least profitable scenario currently yields a profit of $10,000 and gross proceeds from the equally weighted portfolio of $700,000. As the price of Dreck falls, less of the equally weighted portfolio can be purchased from the proceeds of the short sale. When Drecks price falls by more than a factor of 10,000/700,000, arbitrage no longer will be feasible, because the profits in the worst state will be driven below zero. To see this, suppose that Drecks price falls to $10 (1 - 1/70). The short sale of 300,000 shares now yields $2,957,142, which allows dollar investments of only $985,714 in each of the other shares. In the high real interest rate-low inflation sce- nario, profits will be driven to zero:     Dollar In vestment Rate of Return Dollar Return   985,714 $197,143 Bull 985,714 690,000 ush 985,714 -.20 -197,143 Dreck -2,957,142 -690,000 otal     At any price for Dreck stock below $10 (1 - 1/70) $9.857, profits are negative, which means this arbitrage opportunity is eliminated. Note: $9.857 is not the equi- librium price of Dreck. It is simply the upper bound on Drecks price that rules out the simple arbitrage opportunity.