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The APT asset pricing model in finance

Jamal Munshi, Sonoma State University, 1992

All rights reserved

The simplest and most commonly used asset pricing model in finance is a one factor
model called the CAPM. It is 'one factor' in the sense that there is only one
explanatory variable and that variable is the risk premium of the market as a whole.

Its simplicity was attacked by Ross and Roll in the 1970s. Ross (1976) felt that
there must be more than one dimension to asset pricing. Roll (1977) claimed that
the CAPM is not 'theory' since it cannot be refuted or tested. In its place Ross (1976)
and Ross and Roll (1980) proposed a multi-factor model which they called the
arbitrage pricing theory or the APT. Several macro-economic variables are used to
explain asset pricing in this model.

Whereas the CAPM relates stock returns to only the 'market' in the linear equation
Ri = Ro + (Rm-Ro)*B1
where Rm is the market rate of return, the APT model states asset returns as a risk
free return plus a linear combination of factors as :
Ri = Go + (G1-Go)*B1 + (G2-Go)*B2 + .... + (Gn-Go)*Bn
where Go can be interpreted as the risk free rate of return and the (Gi-Go) terms are
risk premia demanded for each class of risk defined by the factors B1 to Bn.

Empirical tests of the APT have been inconclusive because no two researchers could
agree on the number and nature of the exogenous variables or the value of their
coefficients (Chen 1983, Chen, Roll and Ross 1983, Roll and Ross 1980,
Kryzanowski et al 1994).

It has also been shown that the model suffers from a statistical weaknesses.
Kryzanowski et al (1994) show that the explanatory variables are correlated. The
correlation implies that an APT regression model suffers from multi-collinearity and
that it will generate unstable coefficients.

It is necessary in such cases to extract orthogonal factors from the raw factors
before the model can be constructed. The problem is that all efforts to generate
orthogonal factors have resulted in one dominant factor implying that only one
factor is needed as in the CAPM. APT models that retain multiple explanatory
variables, typically five factors are used, are therefore unstable.
The instability of the five-factor regression coefficients for the APT is the likely
reason that researchers cannot agree on their values; and the single dominant factor
problem is the likely reason that no empirical investigation of the APT has produced
results that could be shown to be superior to the CAPM. Thus, the entire APT epoch
in financial research turned out to be a multi-collinearity dead end.

Empirical tests of the APT are characterized by the emotional zeal of the authors and
their universal dislike for the CAPM rather than objective scientific inquiry. The APT
model is seductive and it generates a sense among researchers that they could prove
it to be right if they could only come up with the right kind of statistical magic.

A close look at Chen (1983) reveals these aspects of APT research. Chen, a great fan
of the APT, reports that he was unable to find any evidence that the APT is not valid.
In each case, his null hypothesis was that the APT is valid; and in each case, he was
unable to reject this hypothesis.

He did try establish that the APT was better than the CAPM as a predictor; but the
strongest conclusion he could come up with to support that hypothesis is that "the
APT performs VERY WELL against the CAPM" – in other words that it is just as good.

Chen's APT model was built using five factors - a very common number to use. To
his great credit Chen fixed the predictor variables and number of factors a priori to
avoid 'data dredging', that is, to keep adding predictors and factors until you prove
what it is you are out to prove.

An important difference between CAPM and APT in the regression portion of the
empirical test is that the CAPM does not require a statistically significant
relationship to exist between Ri and Rm. It only seeks to extract whatever covariance
that might exist. In contrast, the APT depends on the existence of statistically
significant correlation. Therefore, the APT model cannot be built if the regression
null hypothesis cannot be rejected.

Typically, in APT research, the validity of the linear model is tested with this
hypotheses -

Ho: b1=b2=b3=b4=b5=0
Ha: At least one of the regression weights is non-zero

This is, of course, statistical voodoo. In the APT the entire regression model has to
be correct and valid. Thus the correct hypotheses should be
Ho: at least one of the bi=0 against
Ha: none of the bi=0

Only a rejection of this null hypothesis will lead to the conclusion that the model is
correctly specified - a necessary condition for APT validation.

Each of the regression weights should be tested with a t-test with the appropriate
Bonferonni type adjustment. If any of the weights is not significantly different from
zero, the model is incorrectly specified and the experiment is over. Conclusion; reject

But even with the slanted hypothesis, the data do not suggest that the null
hypothesis can be rejected. Chen presents the regression weights along with the F-
values but no p-values. I computed the p-values and I find that most of the data do
not support the regression hypothesis at the 5% level even without the multiple
comparison correction.

At this point the author retreats to the 10% level without multiple comparison
correction and pushes on. The t-values computed for each of the 20 regression
weights - 5 predictor variables times 4 periods of study - show that only eight of
these are statistically significant. These statistics do not provide support for the APT

Multiple comparisons require a correction to the alpha value to account for low p-
values that would occur by chance in the null distribution. At an alpha rate of 10%
the probability that all 20 samples will fail to reject Ho is 0.90^20 = 12%. That
means that there is an 88% chance that there will be at least one spurious rejection
of Ho even when the samples are drawn from the Ho distribution. To correct for this
error when making n comparisons and hold the experiment-wide error rate to alpha
the comparison alpha must be reduced so that (1-alpha)^20 =90%. This means that
for an experiment-wide error rate of 10%, the comparison alpha must be made at
1%. This flaw in APT research has not been addressed.

Two of the periods studied (1971-1974 and 1975-1978) actually support a one
parameter hypothesis, the model the study is trying to disprove. One period, 1967-
1970 supports a 2-parameter hypothesis. None of the periods support the 5-
parameter hypothesis. The only conclusion that can be reached is that the APT
linear model is mis-specified.
The author shows that the residuals of the of the single parameter CAPM equation
can be explained by throwing in more predictive variables (as one would expect).
However, he does not apply the same test to his own 5 parameter APT model. Would
addition of a 6th and 7th variable, for instance, reduce his error sum of squares in
the APT? Besides, as previously mentioned, the CAPM model does not rely on a
correctly specified regression model that captures all explainable sum of squares.

An asset's total variance of returns can be partitioned into two parts the systematic
and the diversifiable as long as the linear model is valid (regardless of number of
predictor variables). The regression itself is the process that makes this partition.
There is no reason to believe that the predicted returns of two portfolios will be
different purely on the basis of the difference between the total variance of the assets
unless the linear model is incorrect. And there are better and more easily
interpretable tests for the correctness of the linear model.

In Dybvig and Ross (1985) we find further evidence that research into asset pricing
in this era had deteriorated into open warfare between the CAPM camp and the APT
camp. This paper responds to Shanken's charge that the APT suffers from the same
testability problems that the APT camp uses to attack the CAPM. Although Ross
goes to great lengths to refute Shanken's charge, it is clear that Shanken's attack
has softened Ross's vitriol toward the CAPM. In this paper he takes a rather
generous view of CAPM claiming now, that the CAPM and APT are really compatible
and 'imply' each other. It's just a matter of how many factors we want to use
(CAPM=1 factor, APT=k factors).

But he finally reverts to the Ross and Roll critique of the CAPM viz, that it is not
testable since the 'market portfolio' is not observable. The APT, on the other hand,
does not force the empiricist to define the market but allows him to use any subset
of the market portfolio to validate the model. Ross and Roll thus prevail: the CAPM
is not testable but the APT is.

The problem is that this article does not really respond to the Shanken charge that
there is no reason to believe that the eigenvalues of all subset portfolios will be the
same. The APT camp says, in effect, that if the portfolios are 'sufficiently large' then
the assumption 'is not a bad one'. But as Shanken shows, the definition of
'sufficiently large' suffers from the same empirical difficulty as that of defining the
allegedly unobservable 'market portfolio' in the CAPM.

The bottom line is that whether the CAPM is theoretically sound or not, the APT is
not a suitable substitute for asset pricing because it has no empirical support.

Chen, N.F, and Ingersoll, E., Exact pricing in linear factor models with finitely many
assets: A note, Journal of Finance June 1983 page 985
Chen, Naifu, Richard Roll, and Stephen Ross, Economic forces and the stock
market: testing the APT and alternate asset pricing theories, Working paper,
December 1983
Chen, Naifu, Some empirical tests of the theory of arbitrage pricing, Journal of
Finance, Dec 1983 pp 1393, p1414
Dybvig, Phillip, and Ross, Stephen, Yes, the APT is Testable, Journal of Finance,
Sep, 1985
Fama, Eugene, and James MacBeth, Risk, return, and equilibrium, Journal of
Political Economy, 1973, 81, p607
Kryzanowski, Lawrence, Simon Lalancette, and Minh Chau To, Some tests of APT
mispricing using mimicking portfolios, Financial Review, v29: 2, p153, May 1994
Roll, Richard, A critique of the asset pricing theory's tests, Journal of Financial
Economics, March 1977, p129
Roll, Richard and Stephen Ross, An empirical investigation of the arbitrage pricing
theory, Journal of Finance, Dec 1980, p1073
Ross, Stephen, The arbitrage theory of capital pricing, Journal of Economic Theory,
v13, p341, 1976
Sharpe, William, A simplified model for porftolio returns, Management Science,
1962, p277
Sharpe, William, Capital asset prices: a theory of market equilibrium under
conditions of risk, Journal of Finance, v19, p425, 1964