LO 62.4: Describe multifactor models, and compare and contrast multifactor

LO 62.4: Describe multifactor models, and compare and contrast multifactor models to the CAPM.
As mentioned, the CAPM is a single-factor model that looks at the market as the only factor and defines bad times as low returns to the market portfolio. By contrast, multifactor models incorporate other risk factors, including low economic growth, low GDP growth, or low consumption. One of the earliest multifactor models was arbitrage pricing theory (APT), which describes expected returns as a linear function of exposures to common (i.e., macroeconomic) risk factors.
The lessons from multifactor models are similar to the lessons from the CAPM: 1. Diversification is beneficial. In the CAPM, the market removes (diversifies away) idiosyncratic risk. In multifactor models, it is the tradable version of a factor that removes this risk.
2.
Investors have optimal exposures. Each investor has an optimal exposure to the market portfolio (in the CAPM) or to factor risks (in multifactor models).
3. The average investor holds the market portfolio. This is true under both the CAPM and
multifactor models.
4. Exposure to factor risk must be rewarded. In the CAPM, the market factor is priced
in equilibrium. In multifactor models, each factor has a risk premium, assuming no arbitrage or equilibrium.
3. Risk is measured by a beta factor. In the CAPM, an assets risk is measured by its beta. In multifactor models, an assets risk is measured by its factor exposures (i.e., factor betas).
6. Valuable assets have low risk premiums. Assets that have a positive payoff in bad times are attractive, and, therefore, have low risk premiums. In the CAPM, bad times are explicitly defined as low market returns.
P r ic in g Ke r n e l s

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