(BQ) Part 2 book "Investments" has contents: Empirical evidence on security returns, behavioral finance and technical analysis, the efficient market hypothesis, managing bond portfolios, the term structure of interest rates, option valuation, futures markets, equity valuation models,.and other contents. | 10 CHAPTER TEN PART III Arbitrage Pricing Theory and Multifactor Models of Risk and Return THE EXPLOITATION OF security mispricing in such a way that risk-free profits can be earned is called arbitrage. It involves the simultaneous purchase and sale of equivalent securities in order to profit from discrepancies in their prices. Perhaps the most basic principle of capital market theory is that equilibrium market prices are rational in that they rule out arbitrage opportunities. If actual security prices allow for arbitrage, the result will be strong pressure to restore equilibrium. Therefore, security markets ought to satisfy a “no-arbitrage condition.” In this chapter, we show how such no-arbitrage conditions together with the factor model introduced in Chapter 8 allow us to generalize the security market line of the CAPM to gain richer insight into the risk–return relationship. We begin by showing how the decomposition of risk into market versus firm-specific influences that we introduced in earlier chapters can be extended to deal with the multifaceted nature of systematic risk. Multifactor models of security returns can be used to measure and manage exposure to each of many economywide factors such as business-cycle risk, interest or inflation rate risk, energy price risk, and so on. These models also lead us to a multifactor version of the security market line in which risk premiums derive from exposure to multiple risk sources, each with their own risk premium. We show how factor models combined with a no-arbitrage condition lead to a simple relationship between expected return and risk. This approach to the risk–return tradeoff is called arbitrage pricing theory, or APT. In a single-factor market where there are no extra-market risk factors, the APT leads to a mean return–beta equation identical to that of the CAPM. In a multifactor market with one or more extra-market risk factors, the APT delivers a mean-beta equation similar to Merton’s intertemporal
