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

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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. APT only holds at the individual security level if additional assumptions are
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LEC3 - ACCG329 Lecture 3: Factor Pricing Models...

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