Arbitrage Pricing Theory and Multifactor

Models of Risk and Return

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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CAPM Model

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• CAPM : focus on risk premium in pricing assets

• Risk = systematic risk + unsystematic risk
• According to CAPM theory :since unsystematic
risk can be eliminated through diversification;
• Only relevant risk that should be priced is
systematic risk measured by beta


E(rA ) = rf +  AM E(rM ) − rf 
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Assumptions of CAPM
• Individual investors are • Information is costless
price takers and available to all
• Single-period investment investors
horizon • Investors are rational
• No taxes and transaction mean-variance optimizers
costs • There are homogeneous
• Investors are fully expectations
diversified (only • Investors can borrow and
systematic risk) lend at the risk free rate

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Assumptions of CAPM

• Market portfolio contains all securities and

the proportion of each security is its
market value as a percentage of total
market value
• All investors will hold the same portfolio
for risky assets – market portfolio

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Assumptions of CAPM
Risk Reduction through diversification

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Figure 9.2 The Security Market Line

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Critique of CAPM
• Model is based on an inherently
unobservable “market” portfolio.
• Rests on mean-variance efficiency. The
actions of many small investors restore
CAPM equilibrium.
• CAPM describes equilibrium for all assets
• It is difficult to estimate beta
• It is difficult to have no cost or tax

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Example 1:

Risk free= 0.07

Beta= 1.5
Market return = 0.15

The CAPM predicts an expected return

of E(rA) = 0.07 + 1.5 (0.15 − 0.07) =
0.19.

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Single Factor Model

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Single Factor Model

• Returns on a security come from two
sources:
– Common macro-economic factor
– Firm specific events
• Possible common macro-economic
factors
– Gross Domestic Product Growth
– Interest Rates

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Single Factor Model Equation

ri = E ( ri ) +  i F + ei
ri = The actual Return on a firm
E(r i) = the initial expected return
βi= Factor sensitivity or factor loading or factor beta
F = Surprise in macro-economic factor
(F could be positive or negative)
ei = Firm specific events

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Example 2:

You are a financial manager, while analyzing your company

performance you expect the return to be 30%. During this period, the
expected F1 factor rate was 5%, you also know that the sensitivity to
F1 factor is 2.3. From the past experience, you know that your
company-specific surprise is 5%. At the end of year, you gathered these
data: the F1 actually grew by 10%. Calculate the actual return.

ri = E ( ri ) +  i F + ei
= 30% + 2.3(10% - 5%) + 5% = 46.5%

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Two-Factor Model

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Two-Factor Model

ri = E (ri ) + i1F1 + i 2 F2 + ei

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You are a financial manager, while analyzing your company

performance you expect the return to be 3%. During this period, the
expected F1 factor rate was 3%, you also know that the sensitivity to
F1 factor is 0.8. From the past experience, you know that your
company-specific surprise is 5%. At the end of year, you gathered these
data: the F1 actually grew by 10%. While the expected F2 factor rate
was 3%, you also know that the sensitivity to F2 factor is 0.6. From the
past experience. At the end of year, you gathered these data: the F2
actually grew by 6%. Calculate the actual return.

R = 3% +0.8*(10%-3%) + 0.6*(6%-3%)+5% = 15.4%

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Multifactor Models

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Multifactor Models

• Use more than one factor in addition to

market return
– Examples include gross domestic
product, expected inflation, interest
rates, etc.
– Estimate a beta or factor loading for
each factor using multiple regression.

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• Risk has two sources:

– Common macro-economic factors
– Firm specific events
• Possible common macro-economic
factors
– Gross Domestic Product Growth
– Interest Rates

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Macroeconomic factor models

ri = E (ri ) +  iGDPGDP +  iIR IR + ei

ri = Return for security i

βGDP = Factor sensitivity for GDP
βIR = Factor sensitivity for Interest
Rate
ei = Firm specific events

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Example 3
• You are a financial manager and while analyzing your
company performance you expected return to be 15%.
During this period, the expected GDP growth rate was
6%, and expected inflation was 2%, you also know that
the sensitivity to GDP factor is 1.2 and sensitivity to
inflation factor is 0.6. From the past experience you
know that your company-specific surprise is 2%. At the
end of year, you gathered these data: the GDP actually
grew by 7.5%, and the inflation increase was only 1.5%.
• Build the macroeconomic model for your company, and
calculate the total return of your company

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Example 3 : answer
ri = E (ri ) +  iGDPGDP +  iIR IR + ei

• = 15% + 1.2(7.5% - 6%) + 0.6(1.5% - 2%) + 2%

• = 15% + 1.2(1.5%) + 0.6%(-0.5%) + 2%
• = 15% + 1.8% + (-0.3%) + 2%
• =
• E(r) =expected return
• BGDP = GDP beta
• ei = firm specific event
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Where Should We Look for Factors?

• Need important systematic risk factors

– Chen, Roll, and Ross used industrial
production, expected inflation, unanticipated
inflation, excess return on corporate bonds,
and excess return on government bonds.
– Fama and French used firm characteristics
that proxy for systematic risk factors.

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Fundamental factor models

Fama-French Three-Factor Model

rit =  i +  iM RMt +  iSMB SMBt +  iHML HMLt + eit

• Mt = Market risk premium
• SMB = Small Minus Big (firm size)
• HML = High Minus Low (book-to-market ratio)

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Fama-French Three-Factor Model

• Fama-French three-factor model is one of the

most famous asset pricing models. Knowing that
alpha is 1%, market portfolio risk premium is
15%, market beta is -0.8. Small minus big stock
factor is 15% and its beta is 1.60. The high
minus low measure is 7%, with a beta of 0.7,
and company specific is zero
• Required: build the Fama-French model and
find the return.
rit =  i +  iM RMt +  iSMB SMBt +  iHML HMLt + eit
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Fama-French Three-Factor Model

• Answer:
•rit =  i +  iM RMt +  iSMB SMBt +  iHML HMLt + eit

alph 1% 1%
Bm -0.8
RM 15% -0.12

Bs 1.60

SMB 15% 0.24

Bh 0.7
hml 7% 0.049
E 0.00% 0.00%
r 18%

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Fama-French Three-Factor Model

• Fama-French three-factor model is one of the

most famous asset pricing models. Knowing that
alpha is 1%, market portfolio risk premium is
15%, market beta is -0.8. Small minus big stock
factor is 12% and its beta is 1.60. The high minus
low measure is 7%, with a beta of 0.7, and
company specific is 0.40%
• Required: build the Fama-French model and
find the return.
rit =  i +  iM RMt +  iSMB SMBt +  iHML HMLt + eit
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Fama-French Three-Factor Model

• Answer:

rit =  i +  iM RMt +  iSMB SMBt +  iHML HMLt + eit

13.5% = 1% + [-0.8 x 15%] + [1.6 x 12%] + [0.7 x 7%] + 0.4%

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