When securities are priced so that there are no risk-free arbitrage opportunities, we say that they satisfy the no-arbitrage condition. Price relationships that satisfy the no- arbitrage condition are important because we expect them to hold in real-world markets. 5. Portfolios are called "well-diversified" if they include a large number of securities and the investment proportion in each is sufficiently small. The proportion of a security in a well-diversified portfolio is small enough so that for all practical purposes a reasonable change in that securitys rate of return will have a negligible effect on the portfolios rate of return. 6. In a single-factor security market, all well-diversified portfolios have to satisfy the ex- pected return-beta relationship of the security market line to satisfy the no-arbitrage condition. 7. If all well-diversified portfolios satisfy the expected return-beta relationship, then all but a small number of securities also must satisfy this relationship. 8. The assumption of a single-factor security market made in the simple version of the APT, together with the no-arbitrage condition, implies the same expected return-beta re- lationship as does the CAPM, yet it does not require the restrictive assumptions of the CAPM and its (unobservable) market portfolio. The price of this generality is that the APT does not guarantee this relationship for all securities at all times. 9. A multifactor APT generalizes the single-factor model to accommodate several sources of systematic risk.       KEY TERMS arbitrage zero investment portfolio risk arbitrage arbitrage pricing theory well-diversified portfolio factor portfolio III. Equilibrium In Capital Markets 11. Arbitrage Pricing Theory The McGraw−Hill Companies, 2001           CHAPTER 11 Arbitrage Pricing Theory 335     PROBLEMS 1. Suppose that two factors have been identified for the U.S. economy: the growth rate of industrial production, IP, and the inflation rate, IR. IP is expected to be 3%, and IR 5%.