Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
CHAPTER TEN
ARBITRAGE PRICING THEORY AND MULTIFACTOR
MODELS OF RISK AND RETURN
CHAPTER OVERVIEW
This chapter extends the analysis of the index model of the prior chapter to develop multifactor models
and the arbitrage-pricing framework. The chapter begins with development of single and multifactor
LEARNING OBJECTIVES
After studying Chapter ten, the student should also have a thorough understanding of factor models and
PRESENTATION OF MATERIAL
10.1 Multifactor Models: An Overview
This section opens with the derivation of the single factor model. The single factor model uses a single
10.2 Arbitrage Pricing Theory
The concept of arbitrage and how it relates to single and multi factor models is the topic of discussion for
this section. Arbitrage opportunities exist if an investor can construct a zero investment portfolio with a
sure profit. If such opportunities exist, an investor can take large positions to secure riskless profits. In
10.3 The APT, the CAPM, and the Index Model
Considering the APT relies on an observable market index portfolio and the CAPM relies on an
Chapter 10 – Arbitrage Pricing Theory and Multifactor Models of Risk and Return
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10.4 A Multifactor APT
10.5 The Fama-French (FF) Three-Factor Model