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APTWhat Is It? Estimating and Testing APT APT and CAPM Conclusion
A PT Model
The APT assumes that the stochastic process generating asset returns can be represented as a K factor model of the form: 1. Returns (rate or total) on individual assets follow a multi-index model: N
Ri = ai bik I K ei
K 1
where ai, bi1, . . . , biK are (asset-specific) constants. I1, I2, . . . , IK are random variables which represent factors or indices which affect asset returns. ei is a noise term with mean zero Impose usual model assumptions for multi-index model: cov(Ii, Ik) = 0 , i K cov(IK, ei) = 0 cov(ei, eK) = 0 , I K
where: = the expected return on an asset with zero 0 systematic risk where 0 0 1 = the risk premium related to each of the common factors - for example the risk premium related to interest rate risk
bik = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor K
(3 .03)
(bx1 .50)
(by1 .50)
(bx 2 1.50)
(by 2 1.75)
Ei 0 1bi1 2bi 2
These response coefficients indicate that if these are the major factors influencing asset returns, asset Y is a higher-risk asset, and therefore its expected (required) return should be greater, as shown below:
= .03 + (.01)bi1 + (.02)bi2 Ex = .03 + (.01)(0.50) + (.02)(1.50) = .065 = 6.5% Ey = .03 + (.01)(2.00) + (.02)(1.75) = .085 = 8.5%
If the prices of the assets do not reflect these returns, we would expect investors to enter into arbitrage arrangements whereby they would sell overpriced assets short and use the proceeds to purchase the underpriced assets until the relevant prices were corrected.
Burmeister and McElroy (1988 Financial Analyst Journal) suggested the following factors:
1. Unanticipated changes in the term structure (20-year Government bonds vs. Corporate 2. Unanticipated changes in bond default premiums (Government bonds vs. Corporate). 3. Unanticipated changes in inflation 4. Unanticipated changes in growth rate of corporate profits, and 5. Unanticipated changes in residual market risk.