Summary: Index Models and the Arbitrage Pricing

Theory
1) A single-factor model of the economy classifies sources of uncertainty as systematic
(macroeconomic) factors or firm-specific (microeconomic) factors. The index model
assumes that the macro factor can be represented by a board index of stock return.
2) The single-index model drastically reduces the necessary inputs into the Markowitz
portfolio selection procedure. It also aids in specialization of labour in security
analysis.
3) If the index model specification is valid, then the systematic risk of a portfolio or asset
2 2
equals 𝛽 2 𝜎𝑀 , and the covariance between two assets equals 𝛽𝑖 𝛽𝑗 𝜎𝑀
4) Multifactor models seek to improve the explanatory power of single-factor models by
explicitly accounting for the various systematic components of security risk. These
models use indicators intended to capture a wide range of macroeconomic risk factors.
5) Once we allow for multiple risk factors, we conclude that the security market line also
ought to be multidimensional, with exposure to each risk factor contributing to the
total risk premium of the security.
6) A risk-free arbitrage opportunity arises when two or more security prices enable
investors to construct a zero net investment portfolio that will yield a sure profit.
Rational investors will want to take infinitely large positions in arbitrage portfolios
regardless of their degree of risk aversion.
7) The presence of arbitrage opportunities and the resulting large volume of trades will
create pressure on security prices. This pressure will continue until prices reach levels
that preclude arbitrage.
8) When securities are priced so that there are no risk-free arbitrage opportunities, we say
that they satisfy the no-arbitrage condition. Price relationship that satisfy the no-
arbitrage condition are important we expect them to hold in real-world markets.
9) Portfolios are called well diversified if they include a large number of securities and
the investment proportion in each is sufficiently small. The proportion of a security in
a well-diversified portfolio is small enough so that, for all practical purposes, a
reasonable change in that security’s rate of return will have a negligible effect on the
portfolio rate of return.
10) In a single-factor security market, all well diversified portfolios have to satisfy the
expected return-beta relationship of the security market line in order to satisfy the no-
 arbitrage condition. If all well-diversified portfolios satisfy the expected retun-beta
relationship, then all but small number of securities also satisfy this relationship.
11) The APT does not require the restrictive assumptions of the CAPM and its
(unobservable) market portfolio. The price of this generally is that the APT does not
guarantee this relationship for all securities at all times.
12) A multifactor APT generalizes the single-factor model to accommodate several
sources of systematic risk. The multidimensional security market line predicts that
exposure to each risk factor contributes to the security’s total risk premium by an
amount equal to the factor beta times the risk premium of the factor portfolio that
tracks that source of risk.