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Sequential Tests of the Arbitrage Pricing Theory: A Comparison of Principal Components and Maximum Likelihood Factors

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  • Shukla, Ravi
  • Trzcinka, Charles

Abstract

The authors examine the cross-sectional pricing equation of the arbitrage pricing theory using the elements of eigenvectors and the maximum likelihood factor loadings of the covariance matrix of returns as measures of risk. The results indicate that, for data assumed stationary over twenty years, the first vector is a surprisingly good measure of risk when compared with either a one-factor or a five-factor model or a five-vector model. The authors conclude that principal components analysis may be preferred to factor analysis in some circumstances. Copyright 1990 by American Finance Association.

Suggested Citation

  • Shukla, Ravi & Trzcinka, Charles, 1990. " Sequential Tests of the Arbitrage Pricing Theory: A Comparison of Principal Components and Maximum Likelihood Factors," Journal of Finance, American Finance Association, vol. 45(5), pages 1541-1564, December.
  • Handle: RePEc:bla:jfinan:v:45:y:1990:i:5:p:1541-64
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    Cited by:

    1. Ladrón de Guevara Cortés Rogelio & Torra Porras Salvador, 2014. "Estimation of the underlying structure of systematic risk with the use of principal component analysis and factor analysis," Contaduría y Administración, Accounting and Management, vol. 59(3), pages 197-234, julio-sep.
    2. Leger, Lawrence & Leone, Vitor, 2008. "Changes in the risk structure of stock returns: Consumer Confidence and the dotcom bubble," Review of Financial Economics, Elsevier, vol. 17(3), pages 228-244, August.
    3. Mahsa Ghorbani & Edwin K. P. Chong, 2018. "Stock Price Prediction using Principle Components," Papers 1803.05075, arXiv.org.
    4. Huang, Roger D. & Jo, Hoje, 1995. "Data frequency and the number of factors in stock returns," Journal of Banking & Finance, Elsevier, vol. 19(6), pages 987-1003, September.
    5. Civitarese, Jamil, 2016. "Volatility and correlation-based systemic risk measures in the US market," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 459(C), pages 55-67.
    6. Simon Freyaldenhoven, 2017. "A Generalized Factor Model with Local Factors," 2017 Papers pfr361, Job Market Papers.
    7. Gallo, John G. & Swanson, Peggy E., 1996. "Comparative measures of performance for U.S.-based international equity mutual funds," Journal of Banking & Finance, Elsevier, vol. 20(10), pages 1635-1650, December.
    8. Peter Karlsson, 2011. "The Incompleteness Problem of the APT Model," Computational Economics, Springer;Society for Computational Economics, vol. 38(2), pages 129-151, August.

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