Using Canonical Correlation to Identify Arbitrage Pricing Theory Factors

Abstract

This paper presents a new research design to test the efficacy of the Arbitrage Pricing Theory of Ross [1976], similar to that applied by Christofi, Christofi and Philippatos [1993]. In particular, we use a combination of factor analysis and canonical correlation to test the underlying relationships between APT factors developed using factor analysis and unanticipated changes in five macro‐economic variables that have been shown to be related to stock returns. The results of this paper indicate that the first factor of industry returns is strongly related to the S&P 500 while the remaining four factors are highly correlated with the term structure of interest rates, the rate of inflation, the default premium, and the industrial production, respectively.

Citation

McGowan, C.B. and Dobson, W. (1993), "Using Canonical Correlation to Identify Arbitrage Pricing Theory Factors", Managerial Finance, Vol. 19 No. 3/4, pp. 86-92. https://doi.org/10.1108/eb013719