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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
FACTOR MODELS
SECURITY PRICING FORMULA:
FACTOR MODELS
where
r b e
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