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Unformatted text preview: Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 9 Chapter 9 – Multifactor Models of Risk and Return Questions to be answered: • What are the deficiencies of the CAPM as an explanation of the relationship between risk and expected asset returns? • What is the arbitrage pricing theory (APT) and what are its similarities and differences relative to the CAPM? • What are the strengths and weaknesses of the APT as a theory of how risk and expected return are related? • How can the APT be used in the security valuation process? • How do you test the APT by examining anomalies found with the CAPM? Chapter 9  Multifactor Models of Risk and Return • What are multifactor models and how are they related to the APT? • What are the steps necessary in developing a usable multifactor model? • What are the two primary approaches employed in defining common risk factors? • What are the main macroeconomic variables used in practice as risk factors? Chapter 9  Multifactor Models of Risk and Return • What are the main security characteristicoriented variables used in practice as risk factors? • How can multifactor models be used to identify the investment “bets” that an active portfolio manager is make relative to a benchmark? • How are multifactor models used to estimate the expected risk premium of a security or portfolio? Arbitrage Pricing Theory (APT) • CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark • An alternative pricing theory with fewer assumptions was developed: • Arbitrage Pricing Theory Arbitrage Pricing Theory  APT Three major assumptions: 1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty 3. The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or indexes Assumptions of CAPM That Were Not Required by APT APT does not assume • A market portfolio that contains all risky assets, and is meanvariance efficient • Normally distributed security returns • Quadratic utility function Arbitrage Pricing Theory (APT) For i = 1 to N where: = return on asset i during a specified time period = expected return for asset i = reaction in asset i ’s returns to movements in a common factor = a common factor with a zero mean that influences the returns on all assets = a unique effect on asset i ’s return that, by assumption, is completely diversifiable in large portfolios and has a mean of zero i k ik i i i i t t b b b E R ε δ + + + + + = ... 2 1 R i E i b ik k i Arbitrage Pricing Theory (APT) for i = 1 to n where: R i = actual return on asset i during a specified time period E(R i ) = expected return for asset i if all the risk factors have zero changes b ij = reaction in asset i ’s returns to movements in a common factor j = a set of common factors or indexes with a zero...
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 Spring '09
 YOST
 Management, Capital Asset Pricing Model, Financial Markets, Modern portfolio theory, Arbitrage Pricing Theory

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