Lecture 11 Oct 17 2011

Lecture 11 Oct 17 2011 - FINA 3104: Investment Analysis and...

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Unformatted text preview: FINA 3104: Investment Analysis and Portfolio Management Lecture 11 – APT and Multifactor Models (Continued) Darwin Choi October 17, 2011 Recap from Last Lecture • Introduction to Multifactor Models • Multiple Factors + Firm ‐ specific Risk • Arbitrage Pricing Theory (APT) • No Arbitrage Condition • Well ‐ Diversified Portfolios and APT • Portfolio ‐ Specific Risk ≈ • Arbitrage with Well ‐ Diversified Portfolios • When Betas are Equal • When Betas are Not Equal 2 Outline of Today’s Lecture • Arbitrage with Well ‐ Diversified Portfolios • Arbitrage in Multifactor Models • Connecting APT to SML to CAPM • Finding Factors • Testing the APT 3 • APT applies to well diversified portfolios and not necessarily to individual securities • Because “Well ‐ diversified Portfolio” 2 ( e P ) • If you create an arbitrage opportunity with two individual securities, you are still exposed to firm ‐ specific risks • e.g., if you buy security A and short security B, you make an arbitrage in expectations , but are still exposed to 2 ( e A ) and 2 ( e B ) Why Well ‐ Diversified Portfolios? 4 • Form well ‐ diversified portfolios to arbitrage • Suppose the expected return ‐ beta relationship is violated for some individual securities, create a pair of well ‐ diversified portfolios involving these securities to arbitrage • Can create many pairs – All these different, well ‐ diversified portfolios should obey APT • APT applies to almost all individual securities • It is still possible to have a few violations because well ‐ diversified portfolios have a tiny position in each security How About Individual Securities?...
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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 11 Oct 17 2011 - FINA 3104: Investment Analysis and...

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