Economics 434: The Theory of
Financial Markets
Professor Burton
Fall 2016
October 25, 2016
CAPM Problems
• Unsatisfying “statistical” theory
• Broad criticism
– Roll’s critique
– Lack of empirical validation (Fama-French)
• Problems with “diversification” notion
• Data problems
October 25, 2016
Which Way to Go from CAPM
• Arbitrage Pricing Theory, 1977, Steve Ross
• Finite State Version of CAPM
October 25, 2016
Arbitrage Pricing Theory
• Developed by Steve Ross, 1976
• Uses “No-Arbitrage” Assumption
• Designed to provide “economic” variables to
the determination of asset pricing
• Avoids the “single risky asset portfolio”
problem
October 25, 2016
The Starting Point of APT
𝑅𝑖 = 𝐸 𝑅𝑖 + β𝑖1 𝐹1 + β𝑖2 𝐹2 + … +β𝑖𝑛 𝐹𝑛
Ri is the return in a single period for stock i
𝐸 𝑅𝑖 Is the expected return of stock i
𝐹𝑖 is the “unanticipated” change in factor i
October 25, 2016
After a bit of linear algebra and taking a limit of
arbitrage portfolios that increase in size
𝐸 𝑅𝑖 − 𝑅𝑓 = β𝑖1 γ1 + β𝑖2 γ2 + …β𝑖𝑛 γ𝑛
What is γ1 ?
γ𝑖 = E 𝐹𝑅𝑖 − 𝑅𝑓
The expected excess return attributable to a
beta of one exposure to factor i
October 25, 2016
So, What are the Economic Factors
• According to Richard Roll & Steve Ross
– Inflation
– Industrial production
– Risk premiums (credit spreads)
– Slope of the term structure of interest rates
October 25, 2016
October 25, 2016