Arbitrage pricing theory (APT)

Question 1

BWB ‘ (T)

Answer 1

This part represents the systematic (factor-driven) risk. It captures how the factors’ variances and covariances, along with each asset’s factor loadings, contribute to the overall risk of each asset.

Question 2

V_e

Answer 2

This part represents the idiosyncratic (asset-specific) risk, which is unique to each asset and uncorrelated with the systematic factors.

Question 3

Advantage of Factor Models for Estimation

Answer 3

Factor models reduce estimation uncertainty because they use fewer parameters by modeling the returns based on a few systematic factors rather than estimating individual covariances for each asset.