ARBITRAGE PRICING THEORY

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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 2 .

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 3 .

.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 e is the error term 4 . .

.rRF)bi2+ . +(d-rRF)biK 5 . . . .FACTOR MODELS • SECURITY PRICING FORMULA: ri = l0 + l1 b1 + l2 b2 +.+ lKbK where ri = rRF +(d1-rRF )bi1 + (d2.

FACTOR MODELS where r l0 b e is the return on security i is the risk free rate is the factor is the error term 6 .

FACTOR MODELS • hence – a stock’s expected return is equal to the risk free rate plus k risk premiums based on the stock’s sensitivities to the k factors 7 .

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