ER Rf p 1ER Rf J p2 ER Rf J Pn ER Rf J

where

Rf = Expected return on a zero-beta portfolio

E(Rj) = Expected return on a portfolio with a factor beta of 1 for factor j and zero for all other factors.

The terms in the brackets can be considered to be risk premiums for each of the factors in the model.

The capital asset pricing model can be considered to be a special case of the arbitrage pricing model, where there is only one economic factor driving market-wide returns and the market portfolio is the factor. E (R ) = Rf + p m E (Rm )- Rf )

The APM in Practice

The arbitrage pricing model requires estimates of each of the factor betas and factor risk premiums in addition to the riskless rate. In practice, these are usually estimated using historical data on asset returns and a factor analysis. Intuitively, in a factor analysis, we examine the historical data looking for common patterns that affect broad groups of assets (rather than just one sector or a few assets). A factor analysis provides two output measures:

1. It specifies the number of common factors that affected the historical return data

2. It measures the beta of each investment relative to each of the common factors and provides an estimate of the actual risk premium earned by each factor.

The factor analysis does not, however, identify the factors in economic terms. In summary, in the arbitrage pricing model, the market risk is measured relative to multiple unspecified macroeconomic variables, with the sensitivity of the investment relative to each factor being measured by a beta. The number of factors, the factor betas and factor risk premiums can all be estimated using the factor analysis.

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