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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 + + + + + = ... 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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This note was uploaded on 08/29/2009 for the course BUS Invt taught by Professor Yost during the Spring '09 term at W. Florida.
 Spring '09
 YOST
 Management

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