10.handout - Chapter10 RiskandReturn Thursday APT...

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7/27/2011 1 Chapter 10 The Arbitrage Pricing Theory and Multifactor Models of Risk and Return Thursday: APT Read Chapter 10 & start problems Friday: Finish Chapter 10 problems & Excel assignment Monday: Chapter 11 – The Efficient Market Hypothesis APT – Developed by Stephen Ross [1976] Concerns with the CAPM The Arbitrage Pricing Theory (1) Strong assumptions about preferences (2) Empirical evidence Main Assumptions of APT (1) Security returns can be described (generated) by a factor model (2) There are sufficient securities (a large number relative to factors) to diversify away idiosyncratic risk (3) No arbitrage opportunities
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7/27/2011 2 APT – Developed by Stephen Ross [1976] What is appealing? The Arbitrage Pricing Theory (1) The market portfolio is not assumed to have a central role (2) Multiple economic factors may contribute to return generation Problem What are the factors? Arbitrage “An arbitrage opportunity arises when an investor can earn riskless profits without making a net investment.” Arbitrage “An arbitrage opportunity arises when an investor can earn riskless profits without making a net investment.” Arbitrage Opportunity Notice that a zero net investment implies both a long and short position. Buying T-bills is riskless, but not an arbitrage opportunity. Examples (1) Being able to borrow (riskless) at 5% and lend / invest at 6% (riskless). (2) Doubling strategy? (3) When the same asset trades for a different price in different markets?
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7/27/2011 3 Arbitrage “An arbitrage opportunity arises when an investor can earn riskless profits without making a net investment.” Arbitrage Opportunity
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