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Arbitrage portfolio - factor model

1) In what significant does the APT differ from CAPM ?

2) Why would an investor wish to form an arbitrage portfolio ?

3) What three conditions define an arbitrage portfolio ?

4. Assuming a one-factor model, consider a portfolio composed of three securities with the following factor sensitivities:

Security --- Factor Sensitivity

1 -- 0.90
2 -- 3.00
3 -- 1.80

If the proportion of security 1 on the portfolio is increased by .2 how must the proportions of the other two securities change if the portfolio is to maintain the same factor sensitivity ?

Solution Preview

See attached file.

1) In what significant does the APT differ from CAPM ?

a APT makes lesser number of assumptions than CAPM. In some ways is less complicated than CAPM.
b The market portfolio that is central to CAPM does not feature in APM.
c APT does not tell what the underlying factors are unlike CAPM which relates the return on the asset/portfolio of assets
on a single factor (the return on the market portfolio).

2) Why would an investor wish to form an arbitrage portfolio ?

An investor wishes to form an arbitrage portfolio to increase ...

Solution Summary

The solution explains the differences between APT and CAPM. It also discusses arbitrage portfolio and factor sensitivity

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