The arbitrage pricing theory (APT) describes the expected return on an asset (or portfolio) as a linear function of the risk of the asset with respect to a set of factors. It makes the following assumptions:
Consider a world where investors are broadly diversified, but there may be multiple sources of risk in the economy. Instead of everyone caring solely about the market portfolio, investors actually care about lots of things, including shifts in stock index levels, interest rates, inflation, changes in GDP or other broad macro-economic factors that are difficult to purge from your portfolio through diversification.
The multifactor APT assumes that the stochastic process generating asset returns can be represented as K factor model of the form
The method of exploiting arbitrage opportunities in the APT framework is detailed in the example 12 of the reading.
APT versus Multifactor Models
I. The multifactor APT.
II. The CAPM.
I. interest rate fluctuations.
II. the business cycle.
III. inflation rates.
I. A factor portfolio is a well-diversified portfolio that has a beta coefficient equal to one for a specific factor and zero for all other factors.
II. Since there are many assets, such portfolios can be constructed for each factor.
III. If a portfolio manager wants to bet on a source of risk, he or she may use factor portfolios.
I. capital markets are perfectly competitive.
II. investors always prefer more wealth to less wealth with certainty.
III. The utility function is quadratic in nature.
IV. The stochastic process generating asset returns can be represented as a K factor model.
V. Security returns are normally distributed.
A. I, II and IV.
I. It uses the development of a security's price over time to calculate the expected return.
II. It uses risk premiums based on stock specific variables.
III. It uses key macroeconomic factors relevant to determine a security's returns.
IV. Investors are risk-averse.
A. I and III
I. Quadratic utility function.
II. Normally distributed security returns.
III. A market portfolio that contains all risky assets and is mean-variance efficient.
Which statement is true?
A. I and II only.