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ARBITRAGE PRICING THEORY

ARBITRAGE PRICING THEORY Gur HubermanZhenyu Wang August 15, 2005 AbstractFocusing on asset returns governed by a factor structure, the APT is a one-periodmodel, in which preclusion of ARBITRAGE over static portfolios of these assets leads to alinear relation between the expected return and its covariance with the factors. TheAPT, however, does not preclude ARBITRAGE over dynamic portfolios. Consequently,applying the model to evaluate managed portfolios contradicts the no- ARBITRAGE spiritof the model. An empirical test of the APT entails a procedure to identify featuresof the underlying factor structure rather than merely a collection of mean-varianceefficient factor portfolios that satisfies the linear : ARBITRAGE ; asset PRICING model; factor model. S. N. Durlauf and L. E. Blume,The New Palgrave Dictionary of Economics, forthcoming, PalgraveMacmillan, reproduced with permission of Palgrave Macmillan.

ARBITRAGE PRICING THEORY∗ Gur Huberman Zhenyu Wang† August 15, 2005 Abstract Focusing on asset returns governed by a factor structure, the APT is a one-period model, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The

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