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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.
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