Sunday, December 6, 2009


Concept of Risk under Arbitrage Pricing Model

The risk arising from the firm-specific factors is diversifiable. It is unsystematic risk. The risk arising from the market related factors cannot be diversified. This represents systematic risk. In capital asset pricing model, market risk primarily arises from the sensitivity of an assets returns to the market retains and this is reflected by the assets beta.

Just one factor the market retains affects the firms retain. Hence, capital asset pricing model is one factor model. The betas of the form would differ depending on their individual sensitivity to market. On the other hand Arbitrage pricing model assumes that market risk can be caused by economic factors such as changes in gross domestic product, inflation, and the structure of interest rates and these factors could affects firms differently.

For example; different firms may feel the impact of inflation differently. Therefore, under Arbitrage pricing model, multiple factors may be responsible for the expected return on the share of a firm. Therefore, under Arbitrage pricing model the sensitivity of the assets return to each factor is estimated. For each firm, there will be as many betas as the number of factors.

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