Econ 333 Spring 08
1
Factor Models and the Arbitrage
Pricing Theory

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Econ 333 Spring 08
2
Factor Models and the Arbitrage Pricing
Theory
Our goals:
•
Be able to decompose the variance of an asset into market-related and non market-related
components. i.e. common and firm-specific components.
•
Understand why variance decomposition is important for valuing financial assets.
•
Identify the expected return, factor betas, factors, and firm-specific components of an asset from
its factor equation.
•
Explain how the principle of diversification relates to firm-specific risk.
•
Be able to compute the factor betas for a portfolio given the factor betas of its component
securities.
•
Be able to design a portfolio with a specific configuration of factor betas in order to design
portfolios that perfectly hedge an investment’s endowment of factor risk.
•
Make sense of the arbitrage pricing theory (APT) equation.