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CHAPTER ELEVEN

CHAPTER ELEVEN. 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 smae physical asset or security

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CHAPTER ELEVEN

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  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 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

  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 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

  8. END OF CHAPTER 11

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