1.6 The Arbitrage Pricing Theory and Multifactor Modelf of Risk and Return

Question 1

Does APT identify the specific factors that impact security returns?

Answer 1

No, APT asserts multiple factors exist but does not specify them.

Question 2

Does APT assume that asset returns are normally distributed?

Answer 2

No, APT does not require normally distributed asset returns.

Question 3

What is the basic idea of APT?

Answer 3

Investors can create a zero-beta, zero-net-investment portfolio, and any arbitrage opportunities would be exploited away.

Question 4

What are the three key assumptions of APT?

Answer 4

Systematic factors explain asset returns, diversification eliminates specific risk, and arbitrage opportunities do not persist.

Question 5

Does APT reward investors for accepting specific risk?

Answer 5

No, neither APT nor CAPM rewards investors for specific risk.

Question 6

What are some explanatory variables identified by Chen, Roll, and Ross in testing APT?

Answer 6

Interest rate spread, expected and unexpected inflation, industrial production, and corporate bond yield spreads.

Question 7

What two additional risk factors were introduced in the Fama-French five-factor model?

Answer 7

Operating profitability (RMW) and investment behavior (CMA).

Question 8

What is the book-to-market value factor in the Fama-French model?

Answer 8

HML, which measures the return difference between high and low book-to-market stocks.

Question 9

How does principal component analysis (PCA) relate to statistical factor models?

Answer 9

PCA identifies statistical factors that explain variance in asset returns but does not specify macroeconomic factors.

Question 10

Why do well-diversified portfolios within the same asset class remain highly correlated?

Answer 10

Because diversification is limited when investments are concentrated in a single asset class.

Question 11

What role does arbitrage play in APT?

Answer 11

If a zero-beta portfolio with positive return exists, investors will exploit it until arbitrage opportunities disappear.

Question 12

Why is the change in money supply not an explanatory variable in Chen, Roll, and Ross’s APT test?

Answer 12

Because their test focused on interest rate spreads, inflation, industrial production, and corporate bond yield spreads.

Question 13

How does APT differ from CAPM in explaining risk?

Answer 13

APT considers multiple risk factors, while CAPM relies only on market risk (beta).

Question 14

How does APT view arbitrage in real markets?

Answer 14

It assumes any arbitrage opportunities will quickly be eliminated by market participants.

Question 15

How can factor betas be used to hedge systematic risk?

Answer 15

Investors can buy securities with negative betas to offset positive factor exposures.

Question 16

Why do some investors prefer APT over CAPM?

Answer 16

APT allows multiple risk factors rather than assuming market risk (beta) is the sole driver of returns.

Question 17

How does APT help construct risk management strategies?

Answer 17

By identifying multiple systematic risk factors that can be used to hedge exposure.

Question 18

What does Roll’s critique suggest about diversification?

Answer 18

That diversification within a single asset class does not eliminate high correlations.

Question 19

How does the Fama-French five-factor model improve return explanations?

Answer 19

It adds profitability and investment behavior to market, size, and value factors.

Question 20

How can an investor hedge exposure to a specific APT risk factor?

Answer 20

By shorting securities with high exposure to that factor or buying negatively correlated assets.