Lecture 5 (Chapter 10)

Question 1

Arbitrage Price Theory

Answer 1

1) Security returns can be described by a factor model
2) There are sufficient securities to diversify away idiosyncratic risk
3) Well-functioning security markets do not allow arbitrage opportunities to exist

Question 2

The APT itself does not provide guidance concerning the factors that one might expect to determine risk premiums. How should researchers decide which factors to investigate? Why, for example, is industrial production a reasonable factor to test for a risk premium?

Answer 2

Arbitrage Pricing Theory is a model for Asset Pricing which states that the expected return on an Asset is dependent on the various macro-economic factors and sensitivity to each factor is defined by the factor specific Beta(β). The risk premium can be determined by analysing these factors like GDP, inflation rates etc.

Industrial Production can be considered as a good factor for calculation of risk premium mainly because Industrial Production is directly related to various consumption and investment opportunities in the economy which in turn determine the growth of the economy and thus increasing the returns.