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A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory

Authors

  • PHOEBUS J. DHRYMES,

  • IRWIN FRIEND,

  • N. BULENT GULTEKIN

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    • Dhrymes from Department of Economics, Columbia University, and Friend and Gultekin from The Wharton School, University of Pennsylvania. We owe a great deal to Mustafa N. Gultekin for his generous help in computer programming and for sharing his expertise in computer applications of factor analytic methods with us.

ABSTRACT

This paper demonstrates that the Roll and Ross (RR) and other previously published tests of the APT are subject to several basic limitations. There is a general nonequivalence of factor analyzing small groups of securities and factor analyzing a group of securities sufficiently large for the APT model to hold. It is found that as one increases the number of securities, the number of “factors” determined increases. This increase in the number of “factors” with larger groups of securities cannot readily be explained by a distinction between “priced” and “nonpriced” risk factors as it is impermissible to carry out tests on whether a given “risk factor is priced” using factor analytic procedures.

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