Lecture 10 Oct 12 2011

Lecture 10 Oct 12 2011 - FINA 3104: Investment Analysis and...

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Unformatted text preview: FINA 3104: Investment Analysis and Portfolio Management Lecture 10 – APT and Multifactor Models Darwin Choi October 12, 2011 Recap from Last Lecture • Security Selection Can Be Intractable • Holding ‐ Period vs. Expected Returns • Single ‐ Factor & Single ‐ Index Models • Systemic Risk & Firm ‐ Specific Risk • Two Ways to Compute Security  • Variance ‐ Covariance & Regression 2 Outline of Today’s Lecture • Introduction to Multifactor Models • Arbitrage Pricing Theory (APT) • Well ‐ Diversified Portfolios and APT • Arbitrage with Well ‐ Diversified Portfolios 3 Single ‐ Factor Model: Review r it = E ( r i ) +  i F t + e it r it = Holding ‐ period return for security i in period t E ( r i ) = Expected return for security i at time  i = Sensitivity of security i to the macro factor F t = Unexpected change in macro factor in period t e it = Impact of unanticipated firm ‐ specific events on I • E ( F ) = E ( e i ) = Cov( F , e i ) = Cov( e i , e j ) = 0 4 Single ‐ Index Model (Special Case) r it – r f =  i +  i ( r Mt – r f ) + e it • Compare this with the general case. What is E (r i ) ? • E ( r i ) =  i + r f +  i ( E ( r M ) ‐ r f ) (For your interest, I can rewrite the Special Case as r it =  i + r f +  i ( E ( r M ) ‐ r f ) +  i ( r M ‐ E ( r M )) + e it which has the same form as the previous slide r it = E ( r i ) +  i F t + e it ) 5 Motivating Multifactor Models • Systemic vs. Firm risk sources is compelling... • But the single macro factor assumption is not • Because several factors could explain returns • e.g., GDP, interest rates, inflation, FX rates, etc....
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This note was uploaded on 11/27/2011 for the course FINA 3104 taught by Professor Darwin during the Spring '11 term at HKUST.

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Lecture 10 Oct 12 2011 - FINA 3104: Investment Analysis and...

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