EC3333 Notes05 - Lecture Notes 5 Arbitrage Pricing Theory...

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Lecture Notes 5 Arbitrage Pricing Theory and Factor Models of Risk and Return 1
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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
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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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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. 4
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