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ARBITRAGE PRICING THEORY

Sachin Saini 5/21/2009

Arbitrage Pricing Theory Objectives: Understanding of how APT relates to CAPM. Helps you understand the investors preference Analysis of both long term and short term securities.

Hello, you must have already come across the CAPM and valuation of securities. Recall it just a minute. The Capital Asset Pricing Model (CAPM) is an equilibrium model that describes why different securities have different expected returns. In particular, this positive economic model of asset pricing asserts that securities have different expected returns because they have different betas. However, there exists an alternative model of asset pricing that was developed by Stephen Ross. It is known as Arbitrage Pri cing Theory (APT), and in some ways it is less complicated than the CAPM. The CAPM requires a large number of assumptions, including those initially made by Harry Markowitz when he developed the basic mean-variance model. For example, each investor is assumed to choose his or her optimal portfolio by the use of indifference curves based on portfolio expected returns and standard deviations. In contrast, APT makes fewer assumptions. One primary APT assumption is that each investor, when given the opportunity to increase the return of his or her portfolio without increasing its risk, will proceed to do so, the mechanism for doing so involves the use of arbitrage portfolios. FACTOR MODELS APT starts out by making the assumption that security returns are rela ted to an unknown
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number of unknown factors. For ease of exposition, imagine that there is only one factor and that factor is the predicted rate of increase in industrial production. In this situation, security returns are related to the following one-factor model: ri = a i + b iF1 + e i (1)

where: r1 = rate of return on security F1 = the value of the factor which in this case is the predicted rate of growth in Industrial production e1 = random error term

In this equation, bi is known as the sensitivity of security i to the factor. (It is also
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known as the factor loading for security i or the attribute of security i.) Imagine that an investor owns three stocks and the current market value of his or her holdings in each one is $4,000,000. In this case, the investor's current investable wealth W0 is equal to $12,000,000. .Everyone believes that these three stocks have the, following expected returns and sensitivities: i r1 b1 Stock 1 15% .9 Stock 2 21 3.0 Stock 3 12 1.8 Do these expected returns and factor sensitivities represent an equilibrium situation? If not, what will happen to stock prices and expected returns to restore equilibrium? Principle of Arbitrage In. recent years, baseball card co nventions have become commonplace events. Collectors gather to exchange baseball cards with one another at negotiated prices. Suppose that Ms. A attends such a. gathering where in one corner she finds S offering to sell a 1951 Mickey Mantle rookie card for $400. Exploring the convention further, she finds B bidding $500 for the same card. Recognizing a financial opportunity, Ms. A agrees to sell the card to B, who gives her $500 in cash. She races back to give $400 to S, receives the card, and returns with it to B, who takes possession of the card. Ms. A

pockets the $100 in profit from the two transactions and moves on in search of other opportunities. Ms. A has engaged in a form of arbitrage. Arbitrage is the earning of risk less profit by taking advantage of differential pricing for the same physical asset or security. As a widely applied investment tactic, arbitrage typically entails the sale of a security at a relatively high price and the simultaneous purchase of the same security (or its functional eq uivalent) at a relatively low price. Arbitrage activity is a critical element of modern, efficient security markets. Because arbitrage profits are by definition risk less, all investors have an incentive to take advantage of them whenever they are discovered. Granted, some investors have greater resources and inclination to engage in arbitrage than others. However, it takes relatively few of these active investors to exploit arbitrage situations' and, by their buying and selling actions, eliminate these profit opportunities. The nature of arbitrage is clear when discussing different prices for an individual security. However, "almost arbitrage" opportunities can involve "similar" securities or portfolios. That similarity can be defined in many ways. One interesting way is the exposure to pervasive factors that affect security prices. A factor model implies that securities or portfolios with equal-factor sensitivities will behave in the same way except for non-factor risk. Therefore, securities or portfolios with the same factor sensitivities should offer the same expected returns. If not, then "almost arbitrage" opportunities exist. Investors will take advantage of these opportunities, causing their elimination. That is the essential logic underlying APT. . Arbitrage Portfolios According to APT, an investor will explore the possibility of forming an arbitrage portfolio substantially to increase the expected return of his or her current portfolio without increasing its risk. Just what is an arbitrage portfolio? First of all, it is a portfolio that does not require any additional funds from the investor; If X i denotes the change in

the investor's holdings of security i (and hence the weight of security i in the arbitrage portfolio), this requirement of an arbitrage portfolio can be written as: Xl + X2 + X3 = 0. (2) Second, an arbitrage portfolio has no sensitivity to any factor. Because the sensitivity of a portfolio to a factor is just a weighted average of the sensitivities of the securities in, the portfolio to that factor, this requirement of an arbitrage portfolio can be written as: blX1 + b2X2 + b3X3 = 0 (3a) or, in the current example: .9X1 + 3.0X2 + 1.8X3 = 0. (3b) Thus, in this example, an arbitrage portfolio will have no sensitivity to industrial production. Strictly speaking, an arbitrage portfolio should also have zero non-factor risk. However, the APT assumes that such risk is small enough to be ignored. In its terminology, an arbitrage portfolio has "zero factor exposures." At this point many potential arbitrage portfolios can be identified. These, candidates are simply portfolios that meet the conditions given in Equations (2) and (3b). Note that there are three unknowns (X l , X2, and X3) and two equations in this situation, which means that there is an infinite number of combinations of values for X l, X2, and X3 that
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satisfy , these two equations. As a way of finding one combination, consider arbitrarily assigning a value of.1 to X l , Doing so results in two equations and two unknowns: .1+X2+X3=0 (4a) .09 + 3.0X2 + 1.8X3 = 0. (4b) The solution to Equations (4a) and (4b) is X2 = .075 and X 3 = -.175. Hence a potential arbitrage portfolio is one with these weights.

In order to see if this candidate is indeed an arbitrage portfolio, its expected return
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must be determined. If it is positive, then an arbitrage portfolio will have been identified . Mathematically, this third and last requirement for an arbitrage portfolio is: X1r1 + X2r2 + X3r3 > 0 (5a) or, for this example, 15X1 + 21X2 + 12X3 > 0. (5b) Using the solution for this candidate, it can be seen that its expected return is (15% X .1) + (21% X .075) + (12% X -.175) = .975%. Because this is a positive number, an arbitrage portfolio has indeed been identified. The arbitrage portfolio just identified involves buying $1,200,000 of stock 1 and $900,000 of stock 2. How were these dollar figures arrived at? The solution comes from taking the current market value of the portfolio (W0 = $12,000,000) and multiplying it by the weights for the arbitrage portfolio of X l = .1 and X 2 = .075. Where does the money come from to make these purchases? It comes from selling $2,100,000 of stock 3. (Note that X 3W0 = -.175 X $12,000,000 = -$2,100,000.) In summary, this arbitrage portfolio is attractive to any investor who desires a higher, return and is not concerned with non-factor risk. It requires no additional dollar investment, it has no factor risk, and it has a positive expected return. The Investors Position At this juncture the investor can evaluate his or her position from either one of two equivalent viewpoints: (1) holding both the old portfolio and the arbitrage portfolio or (2) holding a new portfolio. Consider, for example, the weight in stock 1. The old portfolio weight was .33 and the arbitrage portfolio weight was .10, with the sum of these two weights being equal to .13. Note that the dollar value of the holdings of stock 1 in the new portfolio rises to $5,200,000 (= $4,000,000 + $1,200,000), so its weight is .43 (=

$5,200,000/$12,000,000), equivalent to the sum of the old and arbitrage portfolio weights. Similarly, the portfolio's expected return is equal to the sum of the expected returns of the old and arbitrage portfolios, or 16.975% (= 1.6% + .975%). Equivalently, the new portfolio's expected return can be calculated using the new portfolio's weights and the expected returns of the stocks, or 16.975% [= (.43 X 15%) + (.41 X 21 %) + (.16 X 12%)]. The sensitivity of the new portfolio is 1.9 [= (.43 X .9) + (41 X 3.0 ) + (.16 X 1.8)]. This is the same as the sum of the sensitivities of the old and arbitrage portfolios (= 1.9 + 0.0). What about the risk of the new portfolio? Assume that the standard deviation of the old portfolio was 11 %. The variance of the arbitrage portfolio will be small because its only source of risk is non-factor risk. Similarly, the variance of the new portfolio will differ from that of the old only as a result of' changes in its non-factor risk. Thus it can be
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concluded chat the risk of the new portfolio will be approximately 11 %. Tables 1 summarizes these observations. TABLE 1 How an Arbitrator Portfolio Affects an Investors Position Old portfolio Weights: X1 X2 X3 Properties: rp bp p 1 6.000% I. 900 11.000% .975% .000 small 16.975%. 1.900 approx. 11.000% .333 .333 .333 .100 .075 -.175 .433 .408 .158 Portfolio Portfolio + Arbitrage New

PRICING EFFECTS What are the consequences of buying stocks 1 and 2 and selling stock 3? As everyone will be doing so, their market prices will be affected and, accordingly, their expected returns will adjust. Specifically, the prices of stocks 1 and 2 will rise because of increased buying pressure. In turn, this will cause their expected returns to fall. Conversely, the selling pressure put on stock 3 will cause its stock price to fall and its expected return to rise. This can be seen by examining the equation for estimating a stock's expected return:

where P0 is the stock's current price and P1 is the stock's expected end-of-period price. Buying a stock such as stock 1 or 2 will push up its current price Po and thus result in a decline in its expected return r. Conversely, selling a stock such as stock 3 will push down its current price and result in a rise in its' expected return. This buying-and-selling activity will continue until all arbitrage possibilities are significantly reduced or eliminated. At this point there will exist an approximately linear relationship between expected returns arid sensitivities of the following sort: ri = o + 1 bi (7) where Ao and A1 are constants. This equation is the asset pricing equation of the APT when returns are generated by one factor.6 Note that it is the equation of a straight line, meaning that in equilibrium there will be a linear relationship between expected returns and sensitivities.
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In the example, one possible equilibrium setting could have A 0 = 8 and A1 = 4. Consequently, the pricing equation is: r l = 8 + 4bi . (8) This would result in the following equilibrium levels of expected returns for stocks 1, 2, and 3:

r1 = 8 + (4 X .9) = 11.6% r2 = 8 + (4 X 3.0) = 20.0% r3 = 8 + (4 X 1.8) = 15.2%. As a result, the expected returns for stocks 1 and 2 will have fallen from 15% and 21%, respectively, to 11.6% and 20% because of increased buying pressure. Conversely, increased selling pressure will have caused the expected return on stock 3 to rise from 12% to 15.2%. The bottom line is that the expected return on al).y security is, in equilibrium, a linear function of the security's sensitivity to the factor b i. A Graphical Illustration Figure 1 illustrates the asset pricing equation of Equation (7). Any security that has a factor sensitivity and expected return such that it lies off the line will be mispriced according to the APT and will present investors with the opportunity of forming arbitrage portfolios. Security B is an example. If an investor buys security B and sells security S in
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equal dollar amounts, then the investor will have formed an arbitrage portfolio. How can this be?

Figure 1 APT Asset Pricing Line

First of all, by selling an amount of security S to pay for the long position in security B the investor will not have committed any new funds. Second, because securities Band S have the same sensitivity to the factor, the selling of security S and buying of security B will constitute a portfolio with no sensitivity to the factor. Finally, the arbitrage portfolio will have a positive expected return because the expected return of security B is greater
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than the expected return of security S. As a result of investors buying security B, its price will rise and, in turn, its expected return will fall until it is located on the APT asset
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pricing line. Interpreting the APT Pricing Equation How can the constants 0 and l that appear in the APT pricing Equation (12.7) be interpreted? Assuming that there is a riskfree asset in existence, such an asset will have a rate of return that is a constant. Therefore this asset will have no sensitivity to the factor. From Equation (12.7) it can be seen that 1 = 0 for any asset with bi = 0. In the case of the riskfree asset, it is also known that ri = rf implying that 0 = rf . Hence the value of A0 in Equation (12.7) must be rf allowing this equation to be rewritten as: ri = rf + 1bi. (9) In terms of 1, its value can be seen by considering a pure factor portfolio (or pure factor play) denoted p* that has unit sensitivity to the factor, meaning bp* = 1.0. (If there were other factors, such a portfolio would be constructed so as to have no sensitivity to them.) According to Equation (12.9), such a portfolio will have the following expected return: rp* = rf + 1 (12.10a) Note that this equation can be rewritten as: rp* - rf = 1 . (12.10b)

Thus 1 is the expected excess return (meaning the expected return over and above the riskfree rate) on a portfolio that has unit sensitivity to the factor. Accordingly, it is known as a factor risk premium (or factor-expected return premium). Letting 1 = rp* denote the expected return on a portfolio that has unit sensitivity to the factor, Equation (l2.10b) can be rewritten as: 1 - rf = 1. (12.10c) Inserting the left-hand side of Equation (10c) for 1 in Equation (9) results in a second version of the APT pricing equation: ri = rf + (1 - rf ) bi. (11) In the example, because rf = 8% and 1. = % - rf = 4%, it follows that 1 = 12%. This means that the expected return on a portfolio that has unit sensitivity to the first factor is 12%. In order to generalize the pricing equation of APT, the case where security returns are generated by more than one factor needs to be examined. This is done by considering a two-factor model next and then expanding the analysis to k factors where k > 2.

TWO-FACTOR MODELS In the case of two factors, denoted F1 and F2 and representing predicted industrial production and inflation, each security will have two sensitivities, b i1 and bi2. Thus security returns are generated by the following factor model: ri = a i + b i1F1 + bi2F2 + ei . (12) Consider a situation where there are four securities that have the following expected returns and sensitivities. i Stock 1 Stock 2 Stock 3 Stock 4 15% 21 12 8 .9 3.0 1.8 2.0 2.0 1.5 .7 3.2 r1 bi1 bi2

In addition, consider an investor who has $5,000,000 invested in each of the securities. (Thus the investor has initial wealth W0 of $20,000,000.) Are these securities priced in equilibrium? Arbitrage Portfolios To answer this question, the possibility of forming an arbitrage portfolio must be explored. First of all, an arbitrage portfolio must have weights that satisfy the following equations: Xl + X2 + X3 + X4 = 0 (13) .9X1 + 3X2 + 1.8X3 + 2X4 = 0 (14) 2X1 + 1.5X2 + .7X3 + 3.2X4 = 0 (15)

This means that the arbitrage portfolio must not involve an additional commitment of funds by the investor and must have zero sensitivity to each factor. Note that there are three equations that need to be satisfied and that each .equation involves four unknowns. Because there are more unknowns than equations, there are an infinite number of solutions. One solution can be found by setting Xl equal to .1 (an arbitrarily chosen amount) and then solving for the remaining weights. Doing so results in the following weights: X2 = .088, X3 = -.108, and X4 = -.08. These weights represent a potential arbitrage portfolio. What remains to be done is to see if this portfolio has a positive expected return. Calculating the expected return of the portfolio reveals that it is equal to 1.41 % [= (.1 X 15%) + (.088 X 21%) + (-.108 X 12%) + (-.08 X 8%)]. Hence an arbitrage portfolio has been identified. This arbitrage portfolio involves the purchase of stocks 1 and 2, funded by selling stocks 3 and 4. Consequently, the buying-and-selling pressures will drive the prices of stocks 1 and 2 up and stocks 3 and 4 down. In turn, this means that the expected returns of stocks 1 and 2 will fall and stocks 3 and 4 will rise. Investors wi ll continue to create such arbitrage portfolios until equilibrium is reached. This means that equilibrium will be attained when any portfolio that satisfies the conditions given by Equations (13), (14), and (15) has an expected return of zero. This will occur when the following linear relationship between expected returns and sensitivities exists: ri = 0 + lbi1 + 2bi2 (16)

As in Equation (7), this is a linear equation except that it now has three dimensions, ri, bi1 and bi2 Hence it corresponds to the eq uation of a two dimensional plane. In the example, one possible equilibrium setting is where 0 = 8, l = 4, and 2. = - 2. Thus the pricing equation is: ri = 8 + 4bi1 - 2bi2 (17)

As a result, the four stocks have the following equilibrium levels of expected returns: r1 = 8 + (4 X .9) - (2 X 2) = 7.6%

r2 =.8 + (4 X 3) - (2 X 1.5) = 17.0% r3 = 8 + (4 X 1.8) -- (2 X .7) = 13.8% r4 = 8 + (4 X 2) - {2 X 3.2) = 9.6%. The expected returns of stocks 1 and 2 have fallen from 15% and 21 % while the expected returns of stocks 3 and 4 have risen from 12% and 8%, respectively. Given the buying-and-selling pressures generated by investing in arbitrage portfolios, these changes are in the predicted direction. One consequence of Equation (17) is that a stock with higher sensitivity to the first factor than another stock will have a higher expected return if the two stocks also have the same sensitivity to the second factor because l > O. Conversely, since 2 < 0, a stock with higher sensitivity to the second factor will have a lower expected return than another stock with a lower sensitivity to the second factor, provided that both stocks have the same sensitivity to the first factor. However, the effect of two stocks having different sensitivities to both factors can be confounding. For example, stock 4 has a lower expected return than stock 3 even though both of its sensitivities are larger. This is because the advantage of havi ng a higher sensitivity to the first factor (b41 = 2.0 > b31 = 1.8) is not of sufficient magnitude to offset the disadvantage of having a higher sensitivity to the second factor (b42 = 3.2 > b32 = .7).

Pricing Effects
Extending the one-factor APT pricing Equation (7) to this two-factor situation is relatively uncomplicated;-As before, o is equal to the riskfree rate. This is because the riskfree asset has no sensitivity to either factor, meaning that its values of bi1 and bi2 are both zero. Hence it follows that 0.= rf Thus Equation (16) can be rewritten more generally as: ri = rf + 1bi1 + 2bi2 In the example given in Equation (12.16), it can be seen that rf = 8%. (18)

Next consider a well-diversified portfolio that has unit sensitivity to the first factor and zero sensitivity to the second factor. As mentioned earlier, such a portfolio is known- as a pure factor portfolio or pure factor play because it has: (l) unit sensitivity to one factor, (2) no sensitivity to any other factor, and (3) zero non-factor risk. Specifically, it has b1 = l and b2 = 0. It can be seen from Equation (12.18) that the expected return on this portfolio, denoted 1, will be equal to rf + 1.As it follows that 1 - rf = 1. Equation (18) can be rewritten as: ri = rf + (1 rf) bil + 2bi2 (19)

In the example given in Equation (12.16), it can be seen that 1 - rf = 4. This means that 1 =. 12 because rf = 8. In other words, a portfolio that has unit sensitivity to predicted industrial production (the first factor) and zero sensitivity to predict inflation (the second factor) would have an expected return of 12%, or 4% more than the riskfree rate of 8%. Finally, consider a portfolio that has zero sensitivity to the first factor and unit sensitivity to the second factor, meaning that it has b1 = 0 and b2 = 1. It can be seen from Equation (18) that the expected return on this portfolio, denoted 2, will be equal to rf + 2. Accordingly, 2 rf = 2 thereby allowing Equation (12.19) to be rewritten as: ri= rf +(1 -rf) bil + (2 - rf) bi2. (20)

In the example given in Equation (16), it can be seen that 2 - rf = -2. This means that 2 = 6 since rf = 8. In other words, a portfolio that has zero sensitivity to predicted industrial production (the first factor) and unit sensitivity to predict inflation (the second factor) would have an expected return of 6% or 2% less than the risk free rate of 8%.