Multi Factor Models Flashcards
What is Arbitrage Pricing Theory (APT)
Arbitrage Pricing Theory (APT) is a theory that aims to correctly price an
asset, by looking at the sensitivity of the security to market (systematic) risk and not risk that can be diversified away.
However APT takes it a few steps further and is more flexible in its approach to risk.
Rather than focusing on risk that affects the market as a whole and assuming that the investor holds a portfolio identical to the market, instead APT considers the sensitivity
of the security to a range of different market risk factors using the security’s Beta for each factor, known as a factor specific beta (this is the risk premium). Like CAPM this is then
added to the risk-free rate to arrive at the expected return of the asset/security.
What are the problems with Arbitrage Pricing Theory (APT)
It relies on a number of different Betas being calculated for a number of different factors. This is both time consuming and also incomplete since it is impossible to tell whether all of the relevant factors have been taken into consideration. It may well transpire that the factor which ultimately had the biggest influence on returns was not taken into consideration. The kind of factors that might be measured here would be sensitivity to inflation, interest rates, business productivity,
movements in the long term Gilt/T-bill yield curve, changes in bond default risk and possibly exchange rates.
What is the fama and french model?
The fama and french model famously built on CAPM and introduced size of company and value alongside market risk from CAPM as their factors in their multi factor model. The results of which found that small cap companies outperform large cap and value companies (high ratio between book value and share price) outperform growth stocks.
The work of Fama and French, amongst others, has gone on to really drive and develop that of the “value” investing strategy that we know and see today.
