The APT itself does not provide guidance concerning the factors that one might expect to determine risk premiums. How should researchers decide which factors to investigate?
APT Assumptions
Difference in CAPM and APT
CAPM
Investors optimize portfolio demands using a Mü-Sigma approach
One factor model
Mixed empirical evidence
APT
Assumes a factor model of returns
Based on an arbitrage argument (Investors will use all arbitrage opportunity and E(R) will equal the returns)
more than one factors
does not specify the specific factors
Arbitrage Exploitation in CAPM vs. APT
The CAPM is an example of a dominance argument, implying that all investors hold mean-variance efficient portfolios. If a security is mispriced, then investors will tilt their portfolios toward the underpriced and away from the overpriced securities. Pressure on equilibrium prices results from many investors shifting their portfolios, each by a relatively small dollar amount. The assumption that a large number of investors are mean-variance sensitive is critical.
APT implication of a no-arbitrage condition is that a few investors who identify an arbitrage opportunity will mobilize large dollar amounts and quickly restore equilibrium.
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