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CHAPTER 10
Arbitrage Pricing Theory and Multifactor Models of Risk and Return
Investments, 8th edition Bodie, Kane and Marcus
Slides by Susan Hine
McGrawHill/Irwin Copyright © 2009 by The McGrawHill Companies, Inc. All rights reserved.
Single Factor Model
• Returns on a security come from two sources –Common macro-economic factor
–Firm specific events
• Possible common macro-economic factors –Gross Domestic Product Growth –Interest Rates
10-2
Single Factor Model Equation
r = E(r)+biF +e
ri = Return for security I
i = Factor sensitivity or factor loading or factor beta
F = Surprise in macro-economic factor (F could be positive, negative or zero)
ei = Firm specific events
10-3
Multifactor Models
• Use more than one factor in addition to market return
–Examples include gross domestic product, expected inflation, interest rates etc.
–Estimate a beta or factor loading for each factor using multiple regression.
10-4
Multifactor Model Equation
ri = E(ri) + biGDP GDP + bIR IR + ei
ri = Return for security i biGDP= Factor sensitivity for GDP
IR = Factor sensitivity for Interest Rate
ei = Firm specific events
10-5
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