Some empirical tests in the arbitrage pricing theory: Macro variables vs. derived factors

Abstract

This study investigates the ability of two models based on the Arbitrage Pricing Theory (APT) to predict portfolio returns over the period 1971–1986 The difference between the two models lies in the factors used In the factor loading model (FLM), the factors are produced by factor analysis and are thus unspecified In the macroeconomic variable model (MVM), the factors are defined as innovations in a set of macrovariables. The two approaches are compared in several different ways Observed differences in test results between the two models are generally relatively small Given some attractive features of the MVM, such as economically interpretable factors, this finding is encouraging and suggests that factor analysis may be unnecessary in implementing the APT.