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Lecture
Notes 5
Arbitrage Pricing Theory
and
Factor Models of Risk and Return
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*Sign up*Single Factor Model
y
Returns on a security come from two sources
◦
Common macro-economic factor
◦
Firm specific events
y
Possible common macro-economic factors
◦
Gross Domestic Product Growth
◦
Interest Rates
2

Single Factor Model Equation
r
i
= Return for security I
= Factor sensitivity or factor loading or factor
beta
F
= Surprise in macro-economic factor
(F could be positive, negative or zero)
e
i
= Firm specific events
()
ii
i
i
rE
r
F
e
β
=
++
i
3

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*Sign up*Multifactor Models
y
Use more than one factor in addition to market
return
◦
Examples include gross domestic product,
expected inflation, interest rates etc.
◦
Estimate a beta or factor loading for each
factor using multiple regression.
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