Lecture Overview:

• Implications of Portfolio Theory 3/3
• APT and Multifactor Models

Terminology

• Compute the expected return = to price an asset/stock
• Common factor = systematic risk
• Risk premium = price of risk/reward for risk
• A common factor is priced = risk premium > 0
• $\beta$ = exposure to a risk
• Significant $(\alpha,\beta)$ = Significantly different from zero
• Residual risk/return = firm-specific risk/return

Multiple Risk Factors

• In the single factor model, there is only one common (risk) factor.
• In reality, there could be multiple common risk factors that effect stock returns jointly.

$r_i-r_f=\alpha_i+\sum^K_{k=1}\beta_{i,k}(r_k-r_f)+e_i$

• For example: GDP, Inflation, etc.