1. Arbitrage Pricing Theory
Stephen A. Ross’
Arbitrage Pricing Theory

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

3. 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?

4. Arbitrage Pricing Theory
Form riskless portfolio
No arbitrage!

5. 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

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