LEC3 - ACCG329 Lecture 3 Factor Pricing Models Applications...

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1 ACCG329 Lecture 3: Factor Pricing Models - Applications 2009, Semester 1 Egon Kalotay Overview of Lecture First we tidy up some loose ends from last week regarding: Interpretation of APT Estimation and testing of APT We then consider applications of factor models: Modeling the covariance structure of returns Expected return estimation Macro factor betting/hedging
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2 Benefits of APT Framework No strong assumptions about utility functions or the distribution of returns The APT yields a statement about the relative pricing of any subset of assets No special role for the market portfolio CAPM is a single period model, whereas APT is consistent with a multi-period investment horizon Costs of APT Framework The model does not provide any indication of the number or identity of pricing factors only holds by pure arbitrage in a limiting sense. It is only enforced by pure arbitrage if there is no idiosyncratic risk. Enforced by aysmptotic arbitrage requiring a sequence of portfolios to eliminate the error, since the equation above doesn’t hold exactly for a finite number of assets.
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