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ARBITRAGE PRICING THEORY (APT)

Alternative to CAPM developed by Ross (1976)

Based on extension of the Single Price Law for the risky assets.

The Single Price Law for securities : All securities or combinations of securities with the same joint
distributions of return will have the same price in equilibrium.

*A and B are securities with the same joint distributions of return.

Let RA > RB,

* borrow/short sell @ RB and lend/buy RA => riskless profit

* all investors will try to do the same => RA falls, RB rises until RA = RB

APT assumptions:

1. Arbitrage profit = 0

2. The APT description of equilibrium is more general than that provided by the CAPM (e.g. makes no
assumptions about utility functions, distributions, etc.).

An assumption of investors utilizing a mean variance framework (CAPM) is replaced by an assumption

of the process generating security returns:

APT requires that the returns on any stock be linearly related to a set of indices => returns can
be described by a factor model.

3. There is a large number of securities, so that is possible to form portfolios that diversify the firm-
specific risk of individual stocks => firm specific risk does not exist.

4. The financial markets are frictionless

Model:

 the rate of return on any security is a linear function of k factors:

Ri = E(Ri) + bi1F1 + ......+ bikFk + ei

Ri - the random rate of return on the i-th asset

E(Ri) - the expected rate of return on the i-th asset

bik - the sensitivity of the i-th asset's returns to the k-th factor

Fk - the mean zero k-th factor common to the returns of all assets under consideration

ei - a random zero mean noise term for the i-th asset

Rewritten in excess returns form:

E(Ri) – Rf = bi1 (ER1 – Rf) + ....+ bik (ERk – RF)

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* note absence of diversifiable risk ε

ERk – expected return on a portfolio with unit sensitivity to the k-th factor and zero sensitivity to all
other factors

bi1 – defined in exactly the same way as beta in CAPM

bi1= Cov (Ri, ERk)/Var (ERk)

Cov = the covariance between the ith asset’s returns and the linear transformation of the kth factor

Var = the variance of the linear transformation of the k-th factor

CAPM versus APT

1. APT allows any number of factors

2. There is no special role for the market portfolio in the APT

3. In CAPM effect of macro factors (fundamentals) is indirect (through market portfolio), in APT the
effect is direct

4. The CAPM seem to be special case of the APT

5. The CAPM measures risk in one dimension only

If CAPM's b =0.5, according to the APT there is an infinite number of portfolios, all with the same
expected return as portfolio P, and each having different sensitivity to the APT risk parameters b1 and
b2 => If investors are sensitive to more than one type of risk, than the APT is superior to the CAPM.
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Proof of the APT, based on the economic rationale1

Portfolio E(R) bi1 bi2

A 15 1 0.6
B 14 0.5 1
C 10 0.3 .2

 Two points determine a line (CAPM)

 Three points determine a plane

These 3 portfolios define the following space:

Equation 1; 15 = λo + λ1 + 0.6 λ2

Equation 2; 14 = λo + 0.5λ1 + λ2

Equation 3; 10 = λo + 0.3λ1 + 0.2 λ2

1
For more formal proof, see Copeland and Weston textbook, p.220. See also Elton and Gruber
textbook.
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Subtract (1) from (2)

Eq.(4) -1 = -0.5 λ1 + 0.4 λ2subtract (1) from (3)

Eq. (5) -5 = -0.7λ1 - 0.4 λ2

Add (5) to (4)

-6 = -1.2 λ1

λ1 = 5

substitute λ1 = 5 into eq. (4)

-1 = -0.5*5 + 0.4λ2

λ2 = 3.75

substitute λ1 and λ2 into eq. (1)

λo = 15 – 5 – 0.6* 3.75

λo= 7.75

E(Ri) = 7.75 + 5 bi1 + 3.75 bi2The expected return (and risk) of any portfolio constructed from these 3
portfolio lies on the same plane and are given as:

Rp = ∑XiRi

bp1= ∑Xibi1

bp2 = ∑Xibi2

∑Xi = 1

EXAMPLE 1

Assume portfolio D, constructed by investing 1/3 of the funds in A, 1/3 in B, and 1/3 in C.

bp1 = 1/3 (1) + 1/3 (0.5) + 1/3 (0.3) = 0.6

bp2 = 1/3 (0.6) + 1/3 (1) + 1/3 (0.2) = 0.6

The expected returns on D is

1/3 (15) + 1/3 (14) + 1/3 (10) = 13

Alternatively, since portfolio D must lie on the plane, we could have obtained its expected return from
the equation of the plane:

E(Ri) = 7.75 + 5*0.6 + 3.75*0.6 = 13%

EXAMPLE 2

Assume now a portfolio E exists with an expected return of 15%, a bi1=0.6 and bi2 = 0.6. By the law
of one price, two portfolios that have the same risk cannot sell at a different expected return.
Buying portfolio E and financing it by selling D short would guarantee a riskless profit with no
investment and no risk.
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Assume the investor sells £100 worth of portfolio D short and buys £100 worth of portfolio E:

Portfolios Initial CF End of period CF bi1 bi2

D +100 -113 -0.6 -0.6
E -100 115 0.6 0.6

Arbitrage 0 2 0 0

The arbitrage portfolio involves zero investment, has no systematic risk and earns £2. Arbitrage would
continue until E lies on the same plane as A, B, and C.

Empirical tests
Three groups:
1. To find out the number of relevant factors - factor analysis

2. To specify the factors:

- firms specific characteristics
- macro economic factors

3. Direct comparison of CAPM and APT

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1. Specify some values for the factors and bs and maximise R2

st
1 part – analogues to first part regressions in CAPM tests
- collect a time series of daily stock returns data for a group of stocks
- compute the empirical variance-covariance matrix from the returns data
- use a (maximum-likelihood) factor analysis procedure to identify the number of factors
and their factor loadings, bik.

2nd part – analogues to second part regressions in CAPM tests

- use the estimated factor loading bik, to explain the cross-sectional variation of individual
estimated expected returns and to measure the size and statistical significance of the
estimated risk premium associated with each of the factors. Similar to CAPM tests: test
for significance of Rf and slope(s).

Results: Roll and Ross 1980; NYSE and AMEX – 1,260 securities; argue that testing asset pricing
theories should be separated from the investigations about generating process of returns. Suggest 3
factors are relevant.

However, this result is not sufficient to reject the CAPM. Proof:

The simplest case in which an APT is consistent with the simple, single index, form of the CAPM is

Ri = α + βiRm + εi

If returns are generated by a single-index model, the single index is

E(Ri) = Rf + βi (E(Rm) – Rf)

If the return generating function is more complex than this, does it imply that the simple CAPM cannot
hold? The answer is no, since CAPM does not assume that the market is the only source of covariance
between returns.

Let us assume that the return generating process is

Ri = αi + bi1F1 + bi2F2 + ei
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The APT equilibrium model for this return generating process with a risk-free asset is

E(Ri) = Rf + bi1λ1 + bi2 λ2

λj is the excess return on a portfolio with a bij of one on one index and a bij of zero on all other indices.
If the CAPM holds, the equilibrium return on each λj is given by the CAPM

λ1 = β λ1 (Rm – Rf)

λ2 = β λ2 (Rm – Rf)

Substitution in
E(Ri) = Rf + bi1λ1 + bi2 λ2

yields,

E(Ri)=Rf + bi1βλ1[E(Rm)–Rf] + bi2βλ2 [E(Rm)–Rf)

E(Ri)=Rf + (bi1βλ1 + bi2βλ2 ) (E(Rm)–Rf)

Define βi as (bi1βλ1 + bi2βλ2 ) and we can see that the APT solution, with multiple factors appropriately
priced, is fully consistent with the CAPM

E(Ri) = Rf + βi (E(Rm) – Rf)

This is also proof that employing the Roll and Ross procedure and finding that more than one λ j is
significantly different from zero (meaning that more than 1 factor is significant) is not sufficient proof
to reject the CAPM. It is perfectly possible that more than one index explains the covariance between
security returns but that the CAPM holds.
2. Chen, Roll and Ross (1983), tried to find a set of relevant economic variables.

Result: Key factors are:

- Growth of industrial production – affects the opportunity facing investors (discount rate) and
the real value of CFs

- Unexpected inflation – affects both discount rate and the size of the future CFs

- Risk premium – measured as difference between the return on Aaa and Baa bonds.

- Term structure of interest rates – difference in rates for long and short term bonds – affects
discount rate

Problems:

* Macro-economic variables are related and we cannot separate their influence.

e.g. inflation and unemployment

* Therefore we cannot be sure about fundamentals.

* Regression alone, without a theory, does not have intellectual value. Could be o.k. for one sample and
a particular period
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Fama and French (1992, JF; 1996, JF) look at firm specific characteristics as proxies for the
exposure to systematic risk. They find that firms’ size (market value of equity) and BV/MV explain
much of the cross-section of average stock returns for non financial firms on NYSE, 1963-90; (1992).

Beta (for market risk) was not significant! (is CAPM dead?). Over different period, 1941-65, beta (for
market risk) was significant. However, the significance disappeared when size was introduced.

Ri -------//-------- beta (CAPM)

Size

Possible explanation:
If market return (Rm) is a function of economic variables then, beta of the company is a portfolio
of betas which measure sensitivity to a number of economic factors:

Rm = f (set of economic variables) = θo+ b1θ1+b2θ2+b3θ3…

βiCAPM = Cov [Rit (θo+ b1θ1+b2θ2+b3θ3..)]

In the CAPM, the effect of macro economic variables is indirect (through market portfolio). In the
APT the effect is direct.

In 1996 they proposed the following 3-factor model:

Rit = αit + βiMRMt+ βiSMBSMBt + βiHMLHMLt +εit

RM – is market premium
SMB – is size premium (return on small stocks in excess to returns on large stocks)
HML – is growth premium (return on stocks with high book-to-market ratio in excess to returns of
stocks with low book-to-market ratio)
3. Chen (1983) reports that the APT could explain a statistically significant portion of the CAPM
residual variance, but the CAPM could not explain the APT residuals (the CAPM residuals were
regressed on the APT factor loadings, and the APT residuals were regressed on the CAPM
coefficients).

This is so-called nested test:

Rit = αt*Rit (estimated by APT) + (1- αt)*Rit (estimated by CAPM)

αt = 1 => APT holds

αt = 0 => CAPM holds

They found 0.94< αt < 1 ; evidence that the APT is more reasonable model for explaining the
cross sectional variation in assets returns.
Overall
1. APT gives only structure for asset pricing => we do not know the factors (fundamentals)
2. Problem: there is no valid theory behind the chosen factors. Without a theory, the empirical tools are
lot weaker and the results of tests are harder to interpret. For example, we do not know what the size or
sign of factors should be. On the other hand in CAPM the price of beta was supposed to be (Rm-Rf),
we expect positive sign, and have some idea about the magnitude.
3. The number of factors that appear significant is an increasing function of the size of the group
analyzed (Dhrymes et al. 1984).
4. There is fairly strong indication that more than 2 factors affect returns and that more than 2 factors
are priced.
5. The contribution of APT is in demonstrating how (and under what conditions) one can go from a
multi-index model to a description of equilibrium.