Microsoft PowerPoint - PoF.ppt

Assumptionƒ 80

Security returns are correlated for only one reason, i.p.

each security is

assumed to respond to the pull of a single factor

, which is usually

taken to be the market portfolio!

ƒ

Implicit assumption

: 2 types of events produce the period-to-period

variability in a stock’s rate of return:

ƒ

Macro events ... affect nearly all firms

Ä

change in

rM

Ä

change in

rates of return on individual securiti

es (e.g. unexpected change in the rate

of inflation, change in the Federal Reserve discount rate, ...)

ƒ

Micro events ... affect only individual firms

, i.e. they are assumed to

have no effects on other firms and they have no effect on

rM

Ä

cause the

appearance of residuals or deviatio

ns from the characteristic line;

residuals of different companies

are uncorrelated with each other:

Market

F

r

A

r

t J t F F J J t J

=

+

+

=

1

,

,

, 1

1

,

,

ε

β

Single-period random cash flows: Factor models - SFM

2 1

1

,

1

,

́

)

,

(

F F K F J K J

r

r

Cov

σ

β

β

=

⇒

(

)

.

0

,

cov

=

K

J

ε

ε