stock is determined by the price of the stock. For such securities, strict arbitrage is a practical possibility, and the condition of no-arbitrage leads to exact pricing. In the case of stocks and other "primitive" securities whose values are not determined strictly by another asset or bundle of assets, no-arbitrage conditions must be ob- tained by appealing to diversification arguments. III. Equilibrium In Capital Markets 11. Arbitrage Pricing Theory The McGraw−Hill Companies, 2001           324 PART III Equilibrium in Capital Markets     11.2 THE APT AND WELL-DIVERSIFIED PORTFOLIOS   Stephen Ross developed the arbitrage pricing theory (APT) in 1976.2 We begin with a simple version of the model, which assumes that only one systematic factor affects security returns. However, the usual discussion of the APT is concerned with the multifactor case, and we treat this richer model in Section 11.5. Ross starts by examining a single-factor model similar in spirit to the market model in- troduced in Chapter 10. As in that model, uncertainty in asset returns has two sources: a common or macroeconomic factor, and a firm-specific cause. The common factor is as- sumed to have zero expected value, since it measures new information concerning the macroeconomy which, by definition, has zero expected value. There is no need, however, to assume that the factor can be proxied by the return on a market-index portfolio. If we call F the deviation of the common factor from its expected value, i the sensitiv- ity of firm i to that factor, and ei the firm-specific disturbance, the factor model states that the actual return on firm i will equal its initially expected return plus a (zero expected value) random amount attributable to unanticipated economywide events, plus another (zero expected value) random amount attributable to firm-specific events. Formally,   ri E(ri) iF ei where E(ri) is the expected return on stock i. All the nonsystematic returns, the eis, are un- correlated among themselves and uncorrelated with the factor F. To make the factor model more concrete, consider an example. Suppose that the macro factor, F, is taken to be the unexpected percentage change in gross domestic product (GDP), and that the consensus is that GDP will increase by 4% this year. Suppose also that