The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• The Arbitrage Pricing Theory is a general multifactor model for pricing assets. The theory does not provide any specific information about what the factors are. Moreover, the APT does not make any claims on the number of factors either.

• The APT asserts that only taking the systematic risks are rewarded.

• The APT simply assumes that if the returns are driven by the factors, and if investors know the betas for the factors, then an arbitrage portfolio, which requires no investment but yields a positive return, can be formed if the APT pricing relation is violated in the market. In equilibrium, therfore, if there are no arbitrage opportunities, deviations from the APT pricing relation should not be observed.

• In practice, factor models are widely used as a tool for estimating expected asset returns and their covariance matrix. The reason is that if investors can identify the factors that drive asset returns, they will have much better estimates of the true expected asset returns and the covariance matrix, and hence to form a much better portfolio than otherwise possible.

• Factor model estimation depends crucially on (1) whether the factors are identified (known) and unidentified (latent) and (2) the sample size and the number of assets. Furthermore, factor models can be used not only for explaining asset returns, but also for predicting future returns.

• The simplest case of factor models is where the factors are assumed to be known or observable, so that time-series ...