Chapter 11 The Arbitrage Pricing Theory

# Chapter 11 The Arbitrage Pricing Theory - Chapter 11 An...

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Chapter 11 An alternative view of risk and return: The Arbitrage Pricing Theory Returns on securities are interdependent →degree of interdependence between a pair of securities is measured by covariance and correlation Interdependence of returns leads to the CAPM (positive relationship between the beta of a security and its expected return) APT is different as it treats the interrelationship of returns differently o Returns of securities are generated by a number of industry-wide and market- wide factors o Correlation occurs when these two securities are affected by the same factor(s) →CAPM does not specify the factors causing correlation 11.1 Factor Models: Announcements, Surprises, and Expected Returns Examination of the returns on individual securities more closely →find that the portfolios inherit and alter the properties of the securities they comprise The return on any stock traded in a financial market consists of two parts normal or expected return from the stock → which is the part of the return that shareholders in the market predict or expect second part is the uncertain or risky return on the stock → which is the portion that comes from information that will be revealed within the month (i.e. company news, government figures on GNP, a sudden drop in interest rates) A way to write the return on a stock in the coming month is then: R = E(R) + U All information that is revealed but was already expected is already discounted little influence on the market since the market already knew much of it Suppose that a government announced that the actual GNP increase during the year was 1,5%, which is one percent point higher than they had forecast This difference between the actual result and the forecast is called the innovation or surprise →Any announcement can be broken down in two parts, the anticipated or expected part and the surprise or innovation Announcement = Expected part + Surprise The expected part of any announcement is part of information the market uses to form the expectation , R, of the return on the stock The surprise is the news that influences the unanticipated return on the stock, U When we speak of news →we refer to the surprise part of the announcement and not the portion that the market has expected and therefore has already discounted 11.2 Risk: Systematic and Unsystematic The unanticipated part of the return (resulting from surprises) is the true risk of any investment There are important differences , though, among various sources of risk Some are directed specifically (research, president) at one company and some are more general (interest rates, inflation) 1

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Chapter 11 The Arbitrage Pricing Theory - Chapter 11 An...

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