Arbitrage Pricing Theory

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Presentation transcript:

Arbitrage Pricing Theory Stephen A. Ross’ Arbitrage Pricing Theory

Principles of Finance Time value of money No arbitrage Positive relationship between risk and return

Arbitrage Pricing Theory Two sources of risk Common sources? “Factors” Examples? Supposing only common risk Then every security’s return only varies because it depends on the factor: What if β = 0?

Arbitrage Pricing Theory Form riskless portfolio No arbitrage!

But … Not only common risk No predictions about individual securities “Well-diversified” portfolios No predictions about individual securities Construct N-1 “almost-riskless” portfolios Use that to say something

What’s the point? No arbitrage Only need this Positive relationship between risk and return For what kind of risk is one compensated?

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