LECTURE11

# LECTURE11 - Lecture 11 Lecture 11 The Arbitrage Pricing...

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Unformatted text preview: Lecture 11 Lecture 11 The Arbitrage Pricing Theory (APT) The Arbitrage Pricing Theory (APT) Basic Idea APT aims to explain correlation between returns. Whereas CAPM focuses on market risk, the APT argues that each source of systematic risk will have an implicit market price. APT claims the expected return on a risky asset i depends on -- the extent to which each risk affects , measured by a set of beta coefficients analogous to the beta coefficient of CAPM -- the market prices of the different systematic risk i R i R Arbitrage ensures that the same bundle of systematic risks has to sell for the same price. To derive an appropriate risk premium for an asset, we attempt to forecast the systematic risks affecting that asset and then use the implicit market prices of the factors. ( 29 r R i- Expected and Unexpected Returns The expected return on an asset i in any given period is not random, and therefore is not a source of risk. i R i i i u R R + = The ex-post actual return will generally be different from as a result of unanticipated or unexpected shocks : i R i R i u Although is separate from the expected return , risk arises from . Hence, the characteristics of affects expected return . i u i R i u i u i R Systematic and Unsystematic Risk i m i i i i i i i m R u R R + + = + = Decompose as : i i i m u + = i u systematic or market risk can not be eliminated by holding a diversified portfolio unsystematic or idiosyncratic risk can be eliminated by diversification = N as x Var N 1 i i i ( 29 j i for , Cov j i = The market portfolio with N assets, and proportion invested in asset i, the idiosyncratic risk satisfy i x i Systematic and Unsystematic Risk (continued) Unsystematic risk reflects mainly microeconomic shocks affecting relative prices, outputs and employments....
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## This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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LECTURE11 - Lecture 11 Lecture 11 The Arbitrage Pricing...

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