# Investment Analysis & Portfolio Management

Chapter 10

**Arbitrage Pricing Theory and Multifactor Models of Risk and Return
**

FIN 435 (Instructor- Saif Rahman)

**Single Factor Model
**

**Returns on a security come from two sources
**

Common

Firm

macro-economic factor

specific events

**Possible common macro-economic factors
**

Gross

Domestic Product Growth

Interest

Rates

FIN 435 (Instructor- Saif Rahman)

Single Factor Model Equation
ri E (ri ) i F ei
ri = Return for security I
i = Factor sensitivity or factor loading or factor beta
F = Surprise in macro-economic factor (F could be positive.Saif Rahman)
. negative or zero)
ei = Firm specific events
FIN 435 (Instructor.

Saif Rahman)
.Multifactor Models
Use
more than one factor in addition to market return
include gross domestic product. interest rates etc. expected
Examples
inflation.
Estimate
a beta or factor loading for each factor
using multiple regression.
FIN 435 (Instructor.

Multifactor Model Equation
ri = E(ri) + i GDP GDP + i IR IR + ei
ri = Return for security i
i GDP= Factor sensitivity for GDP
i IR = Factor sensitivity for Interest Rate
ei = Firm specific events
FIN 435 (Instructor.Saif Rahman)
.

22. Since no investment is required. The price in Shop A is Tk. an investor can create large positions to secure large levels of profit.arises if an investor can construct a zero investment portfolio with a sure profit. Example – the same product is being transacted in two shops. Risk-less profit with zero initial outlay or investment. Assume buying and selling prices are same.Saif Rahman) The Law of One Price
. the price is Tk.Arbitrage Pricing Theory
Arbitrage . profitable arbitrage opportunities will quickly disappear. 20 whereas in Shop B. In efficient markets. What will happen? How can you make risk-less profit with no initial outlay or investment? How will this arbitrage opportunity disappear in an efficient market? FIN 435 (Instructor.

The APT requires three assumptions: 1) Returns can be described by a factor model 2) There are no arbitrage opportunities 3) There are large numbers of securities that permit the formation of portfolios that diversify the firm-specific risk of individual stocks
FIN 435 (Instructor.Arbitrage Price Theory
The Arbitrage Pricing Theory (APT) is a relatively new theory
of expected asset returns due to Ross (1976). The APT explicitly accounts for multiple factors.Saif Rahman)
.

then there will be an arbitrage opportunity
Note that fewer assumptions are necessary to derive the APT (than are necessary to derive the CAPM)
FIN 435 (Instructor.Arbitrage Price Theory
If
there are K factors. if the portfolio’s expected return (price) is not equal to the expected return predicted by the portfolio’s s. + iKFK + ei
The expected returns of each security will be a function of its factor s The model is derived by showing that for well diversified portfolios.Saif Rahman)
. then the return generating process is:
ri = ai + i1F1 + i2F2 + ……….

15 AC -0.91 BC -0.0 20 32.5 Standard Corr.Arbitrage Example
Current Stock Price$ A 10 B 10 C 10 D 10 Expected Return% 25.% 29.87 48.58
FIN 435 (Instructor. Dev.15 33.5 22.29 8.58 AB -0.Saif Rahman)
.

Saif Rahman)
.83
S.C D
25.25
8.58
FIN 435 (Instructor.
6.40
22.Arbitrage Portfolio
Mean Portfolio A.D.B.

Ret.Saif Rahman)
.Arbitrage Action and Returns
E.
FIN 435 (Instructor. B & C to form P. You earn a higher rate on the investment than you pay on the short sale.Dev.
* P * D St.
Short 3 shares of D and buy 1 of A.

Saif Rahman)
. rP = E (rP) + bPF + eP F = some factor For a well-diversified portfolio: eP approaches zero
FIN 435 (Instructor.APT & Well-Diversified Portfolios
Based on the law of one price Does not rely on mean-variance assumption (as the CAPM does) It assumes that asset returns are linearly related to a set of indexes. Each index represents a factor that influences the return on an asset.

Saif Rahman)
.Comparing a Portfolio with an Individual Security
E(r)% E(r)%
F
Portfoli o
F Individual Security
FIN 435 (Instructor.

5
1.Saif Rahman)
.0
Beta for F
FIN 435 (Instructor.Disequilibrium Example
E(r)%
10 D 7 6 Risk Free 4 C A
.

Disequilibrium Example
Short Portfolio C Use funds to construct an equivalent risk higher return Portfolio D.Saif Rahman)
.
D is comprised of A & Risk-Free Asset
Arbitrage profit of 1%
FIN 435 (Instructor.

0
Beta (Market Index)
FIN 435 (Instructor.rf]
Risk Free
Market Risk Premium
1.APT with Market Index Portfolio
E(r)%
M
[E(rM) .Saif Rahman)
.

or robust. APT can be extended to multifactor models. It is based on less restrictive assumptions.
FIN 435 (Instructor. which is in principle non measureable.APT and CAPM Compared
The CAPM is a special case of APT that would result if the single common factor affecting all security returns was the return on the market portfolio. APT does not identify either the number or the definition of the factors affecting returns.Saif Rahman)
. APT is more general. The CAPM is a well-specified model. than the CAPM. it relies on the Market Portfolio. where the parameters of the model are spelled out up front. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. However. These have to be empirically determined by fitting a factor model to returns.

There is some evidence that the following macroeconomic variables may be risk factors:
1)Changes in monthly GDP 2)Changes in the default risk premium 3)The slope of the yield curve 4)Unexpected changes in the price level
5)Changes in expected inflation Note that the difficulty of measuring expected inflation makes the estimation of 4 & 5 difficult
FIN 435 (Instructor.Saif Rahman)
.Arbitrage Price Theory
In
order to implement the APT we need to know what the factors are! Here the theory gives no guidance.

i.Saif Rahman)
. the return of a portfolio of stocks with a high book to-market ratio in excess of the return on a portfolio of stocks with a low book-to-market ratio
FIN 435 (Instructor. the return of a portfolio of small stocks in excess of the return on a portfolio of large stocks HML = High Minus Low..e. i.Fama-French Three-Factor Model
The factors chosen are variables that on past evidence seem to predict average returns well and may capture the risk premiums
rit i iM RMt iSMB SMBt iHML HMLt eit
Where: SMB = Small Minus Big..e.

Saif Rahman)
.The Multifactor CAPM and the APM
A multi-index CAPM will inherit its risk factors from sources of risk that a broad group of investors
deem important enough to hedge
The APT is largely silent on where to look for priced sources of risk
FIN 435 (Instructor.