ABSTRACT
We then move our focus towards a second and more theoretically plausible approach to asset pricing issues, namely, the Arbitrage Pricing Theory (APT). The basic assumption behind the APT is that it will never be possible to earn a riskless profit from a self-financing (i.e. a zero-cost) investment portfolio. We note how a variety of arbitrage pricing models have arisen out of this basic assumption. Probably the most commonly employed of these models uses what is known as the ‘characteristic polynomial’ associated with a particular correlation matrix to identify a comparatively small number of ‘factors’ through which to account for the off-diagonal terms in the given correlation matrix. This captures the essential feature of what is known as a strict factor model, namely, that the correlation matrix can be
decomposed into a matrix composed of an underlying set of factors and a second diagonal matrix composed purely of idiosyncratic variance terms. We would also emphasize that our emphasis in this chapter is on the two most commonly encountered alternatives to the CAPM to be found in the literature. There are, however, many other approaches to asset pricing theory that, owing to limitations of space, we are unable treat in this chapter.
