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10)
Arbitrage Pricing Theory (APT)
and Multifactor Models of Risk and Return
• Multifactor models
• Arbitrage opportunities and profits
• The APT: A single factor model
– Well-diversified portfolios
– Betas and expected returns
– The security market line
– Individual assets and the APT
– The APT and the CAPM
• A multifactor APT
1
Multifactor Models
2
However, sometimes, rather than using a market
proxy, it is more useful to focus directly on the
ultimate sources of risk.
3
Factor models of security returns
A single-factor model
4
Let E(ri): expected return on stock i
F: deviation of the common factor from its expected
value
βi: sensitivity of firm i to the common factor
ei: firm-specific disturbance
A single-factor model:
ri E ( ri ) i F ei
Example:
6
If GDP increases by only 3%, then the value of F
would be -1%, representing a 1% disappointment in
actual growth versus expected growth.
7
A two-factor model
The systematic or macro factor summarized by the
market return arises from a number of sources (e.g.,
uncertainty about the business cycle, interest rates,
inflation, etc.)
When we estimate a single-index regression, we
implicitly impose an incorrect assumption that each
stock has the same relative sensitivity to each risk factor.
If stocks actually differ in their betas relative to the
various macroeconomic factors, then lumping all
systematic sources of risk into one variable such as the
return on the market index will ignore the nuances that
better explain individual-stock returns. 8
Example:
Suppose the 2 most important macroeconomic
sources of risk are uncertainties surrounding the
state of the business cycle, news of which we will
again measure by unanticipated growth in GDP and
changes in interest rates (IR).
10
• Now, consider 2 stocks, A and B.
When GDP grows, A’s and B’s stock prices will rise.
When interest rates rise, A’s and B’s stock prices will
fall.
11
Suppose that on a particular day, a news item suggests
that the economy will expand.
12
Clearly, a one-factor or single-index model cannot
capture such differential responses to varying sources
of macroeconomic uncertainty.
13
• Two principles guide us when we specify a reasonable
list of factors:
E ( r ) r f [ E ( rM ) r f ] r f RPM
15
We can think of beta as measuring the exposure of a
stock or portfolio to marketwide or macroeconomic
risk factors.
18
Arbitrage Opportunities and Profits
Stock:
A -20 20 40 60
B 0 70 30 -20
C 90 -20 -10 70
D 15 23 15 36
21
The current prices of the 4 stocks and rate of return
statistics:
Correlation Matrix
Expected Standard
Current Return Deviation
Stock Price (%) (%) A B C D
A $10 25.00 29.58 1.00 -0.15 -0.29 0.68
B 10 20.00 33.91 -0.15 1.00 -0.87 -0.38
C 10 32.50 48.15 -0.29 -0.87 1.00 0.22
D 10 22.25 8.58 0.68 -0.38 0.22 1.00
22
Consider an equally weighted portfolio of the first
three stocks (A, B, and C), and contrast its possible
future rates of return with those of D:
23
The rate of return statistics of the 2 alternatives are:
Standard
Mean Deviation Correlation
3-stock portfolio 25.83 6.40 0.94
D 22.25 8.58
25
Investors will want to take an infinite position in such
a portfolio because larger positions entail no risk of
losses, yet yield evergrowing profits.
ri E ( ri ) i F ei
where
E(ri): expected return on stock i
F: deviation of the common factor from its expected
value
βi: sensitivity of firm i to the common factor
ei: firm-specific disturbance
27
Risk of a portfolio of securities
n
Construct an n-asset portfolio with weights wi ( wi 1 ).
i 1
The rate of return on this portfolio:
rP E ( rP ) P F e P
29
Well-diversified portfolios
1 1 1 2
( ei ) 1 2
( e P , wi ) ( ) ( ei )
2 2 2
( ei )
n n n n n
P2 P2 F
2 P P F
Note: Large (mostly institutional) investors can hold
portfolios of hundreds and even thousands of
securities; thus the concept of well-diversified
portfolios clearly is operational in contemporary
financial markets. Well-diversified portfolios,
however, are not necessarily equally weighted. 32
Betas and expected returns
Consider a well-diversified portfolio A with E(rA) =
10% and A = 1.
33
Now consider another well-diversified portfolio B, with
an expected return of 8% and B also equal to 1.0.
34
Clearly not: No matter what the systematic factor
turns out to be, portfolio A outperforms portfolio B,
leading to an arbitrage opportunity.
35
You should pursue it on an infinitely large scale until
the return discrepancy between the two portfolios
disappears.
36
What about portfolios with different betas?
37
38
Consider a new portfolio, D, composed of half of
portfolio A and half of the risk-free asset.
39
Conclusion: To preclude arbitrage opportunities, the
expected return on all well-diversified portfolios
must lie on the straight line from the risk-free asset.
40
Formally:
Suppose that 2 well-diversified portfolios (U & V)
are combined into a zero-beta portfolio, Z, by
choosing the weights shown below:
Expected Portfolio
Portfolio Return Beta Weight
U E(rU) U V
V U
V E(rV) V U
V U
Notes: wU wV 1
V U
Z wU U wV V U V 0
V U V U 41
Portfolio Z is riskless: It has no diversifiable risk
because it is well diversified, and no exposure to the
systematic factor because its beta is zero.
E rZ wU E ( rU ) wV E ( rV )
V U
E ( rU ) E ( rV ) r f
V U V U
E ( rU ) r f E ( rV ) r f
U V
(i.e. risk premiums are proportional to betas)
42
The security market line
44
We have used the no-arbitrage condition to obtain an
expected return-beta relationship identical to that of
the CAPM, without the restrictive assumptions of the
CAPM.
45
In contrast to the CAPM, the APT does not require
that the benchmark portfolio in the SML relationship
be the true market portfolio.
46
The APT provides further justification for use of the
index model in the practical implementation of the
SML relationship.
47
Individual assets and the APT
50
The APT and the CAPM
Similarities:
52
The APT yields an expected return-beta relationship
using a well-diversified portfolio that practically can
be constructed from a large number of securities.
56
Suppose that the two factor portfolios (portfolios 1 &
2) have expected returns E(r1) = 10% & E(r2) = 12%.
57
Now consider an arbitrary well-diversified portfolio,
portfolio A, with beta on the first factor, A1 = 0.5, and
beta on the second factor, A2 = 0.75.
59
Why the expected return on A must be 13%?
61
A long position in B and a short position in A would
yield an arbitrage profit.
r f P 1[ E ( r1 ) r f ] P 2[ E ( r2 ) r f ]