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ARBITRAGE PRICING THEORY

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 same physical asset or security

Arbitrage Portfolio
requires no additional investor funds no factor sensitivity has positive expected returns

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

FACTOR MODELS
MULTIPLE-FACTOR MODELS
FORMULA

ri = ai + bi1 F1 + bi2 F2 +. . . + biKF K+ ei


where r is the return on security i b is the coefficient of the factor F is the factor
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FACTOR MODELS
SECURITY PRICING FORMULA:

ri = 0 + 1 b1 + 2 b2 +. . .+ KbK where ri = rRF + ( 1 RF )bi1 + ( 2 rRF)bi2+ . . . r +( rRF)biK


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FACTOR MODELS

where

r b e

is the return on security i is the factor is the error term

0 is the risk free rate

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

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