where I, GNP, and r stand for inflation, gross national product, and the interest rate, respectively. The three factors FI,FGNP, and Fr represent systematic risk because these factors affect many securities. The term ∈ is considered unsystematic risk because it is unique to each individual security.
For convenience, we frequently describe a security's return according to a one-factor model:
As securities are added to a portfolio, the unsystematic risks of the individual securities offset each other. A fully diversified portfolio has no unsystematic risk but still has systematic risk. This result indicates that diversification can eliminate some, but not all, of the risk of individual securities.
Because of this, the expected return on a stock is positively related to its systematic risk. In a one-factor model, the systematic risk of a security is simply the beta of the CAPM. Thus, the implications of the CAPM and the one-factor APT are identical. However, each security has many risks in a multifactor model. The expected return on a security is positively related to the beta of the security with each factor.
Empirical or parametric models that capture the relations between returns and stock attributes such as P/E or M/B ratios can be estimated directly from the data without any appeal to theory. These ratios are also used to measure the styles of portfolio managers and to construct benchmarks and samples against which they are measured.
