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Abstract:
This paper develops and applies a new maximum likelihood method for estimating the Arbitrage Pricing Theory (APT) model with observable risk factors. The approach involves simultaneous estimation of the factor loadings and risk premiums and can be applied to return panel with more securities than time series observations per security. Observable economic factors are found to account for 25 to 40 percent of the covariation in U.S. equity returns, and the APT pricing restrictions cannot be rejected for most sample periods. A significant "firm size anomaly" is measured, but it may be partly due to sample selection bias.
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