CHAPTER ELEVEN

1
CHAPTER ELEVEN

• ARBITRAGE PRICING THEORY

2
FACTOR MODELS

• ARBITRAGE PRICING THEORY (APT)
• is an equilibrium factor mode of security returns
• Principle of Arbitrage
• the earning of riskless profit by taking
  advantage of differentiated pricing for the smae
  physical asset or security
• Arbitrage Portfolio
• requires no additinal investor funds
• no factor sensitivity
• has positive expected returns

3
FACTOR MODELS

• ARBITRAGE PRICING THEORY (APT)
• Three Major Assumptions
• capital markets are perfectly competitive
• investors always prefer more to less wealth
• price-generating process is a K factor model

4
FACTOR MODELS

• MUTIPLE-FACTOR MODELS
• FORMULA
• ri ai bi1 F1 bi2 F2 . . . biKF Kei
• where r is the return on security i
• b is the coefficient of the factor
• F is the factor
• e is the error term

5
FACTOR MODELS

• SECURITY PRICING
• FORMULA
• ri l0 l1 b1 l2 b2 . . . lKbK
• where
• ri rRF (d1-rRF )bi1 (d2- rRF)bi2 . . .
• (d-rRF)biK

6
FACTOR MODELS

• where r is the return on security i
• l0 is the risk free rate
• b is the factor
• e is the error term

7
FACTOR MODELS

• hence
• a stocks expected return is equal to the risk
  free rate plus k risk premiums based on the
  stocks sensitivities to the k factors

8

• END OF CHAPTER 11