On Testing the Arbitrage Pricing Theory: Inter‐Battery Factor Analysis

Abstract

ABSTRACT This paper tests the Arbitrage Pricing Theory (APT) by estimating the factor loadings that are consistent between two industry groups of securities. One of the pitfalls in the study by Roll and Ross is that the factors estimated in one group may not be the same with the factors estimated in another group. This raises some concerns on the acceptability of their conclusions. For our study, we employ inter‐battery factor analysis which enables us to estimate factor loadings by constraining the factors to be the same between two different groups. Our results show that there seem to be five or six inter‐group common factors that generate daily returns for two industry groups of securities, and these inter‐group common factors do not seem to depend on the size of groups. Also, based on our cross‐sectional tests on the risk premia, we conclude that the APT should not be rejected.