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Unformatted text preview: 12. Additional topics In these slides we briefly discuss Arbitrage pricing theory (APT) Market efficency Behavioral finance APT In the CAPM, expected returns depend upon just a single factor, the assets exposure to market risk . But in fact, there may be several factors driving returns, and different assets may respond to changes in those variables in different ways. Possible factors (other than market returns) that have been suggested in the literature include: inflation GDP growth shortterm interest rates spread between short and longterm bonds energy prices 2 APT continued The arbitrage pricing model (APT) , suggested by Stephen Ross, looks similar to the CAPM, but allows for several factors. The statistical model for asset returns put forward by the APT is R A = R f + n summationdisplay i =1 b Ai i + n summationdisplay i =1 b Ai F i + epsilon1 where R A = the assets return F i = the i th factor b Ai = Asset As exposure to risk associated with the F i (also known as the factor loading ) i = the risk premium associated with F i Notes: Factors should be normalized to mean zero. The CAPM can be interpreted as a special case of this model (with only a single factor). 3 APT continued As with the CAPM, the factor loadings , b Ai , are unknown, but can be estimated by linear regression . But, whereas the CAPM tells us the factor (market excess returns) the risk premium ( E ( r M ) r F ) APT tells us neither. The risk premia can be estimated from data. Deciding what factors to use is more or less a matter of testing different possibilities to see what seems to give good results. 4 Example APT We would like to use a two factor APT model to estimate the expected return for Eagle Aerospace Corp. Suppose that the risk premia are 1 = 3% and 2 = 4% . Based on a regression analysis for Eagles stock returns and the two factors, we estimate that the factor loadings are 1 = 2 and 2 = 1 . 5 ....
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 Fall '07
 DONCHEZ,RO
 Arbitrage, Behavioral Finance, Corporate Finance

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