MULTIFACTOR MODELS OF

RISK AND RETURN

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ARBITRAGE PRICING THEORY
 APT, developed by Ross in the mid-1970s has three
major assumptions:
 Capital markets are perfectly competitive.
 Investors always prefer more wealth to less wealth with
certainty.
 The stochastic process generating asset returns can be
expressed as a linear function of a set of K risk factors (or
indexes), and all unsystematic risk is diversified away.

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ARBITRAGE PRICING THEORY


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COMPARING THE CAPITAL ASSET PRICING
MODEL (CAPM) AND THE ARBITRAGE PRICING
THEORY (APT)

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USING THE APT

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SECURITY VALUATION WITH THE
APT: AN EXAMPLE

 Assume that all three stocks are currently priced at $35 and do not
pay a dividend, What are the expected prices?
 Now, suppose you believe that in one year the actual prices of
stocks A, B, and C will be $37.20, $37.80, and $38.50. How can you
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take advantage of what you consider to be a market mispricing?
 MULTIFACTOR MODELS AND
RISK ESTIMATION
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MACROECONOMIC-BASED RISK
FACTOR MODELS


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BURMEISTER, ROLL, AND ROSS (1994)
MACRO ECONOMIC FACTOR MODEL
 Confidence risk
 Time horizon risk

 Inflation risk

 Business cycle risk

 Market-timing risk

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MICROECONOMIC-BASED RISK
FACTOR MODELS
 Fama and French (1993)

 Carhart (1997) four factor model

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ESTIMATING A MULTIFACTOR MODEL WITH
CHARACTERISTIC-BASED RISK FACTORS


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EXTENSIONS OF CHARACTERISTIC-
BASED RISK FACTOR MODELS
 Volatility (VOL)  Earnings Yield (EYL)
 Momentum (MOM)  Value (VAL)
 Size (SIZ)  Earnings Variability
 Size Nonlinearity (SNL) (EVR)
 Trading Activity (TRA)  Leverage (LEV)

 Growth (GRO)  Dividend Yield (YLD)

 Non-estimation Indicator
(NEU)

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ESTIMATING RISK IN A MULTIFACTOR
SETTING: EXAMPLES

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COMPARING MUTUAL FUND RISK
EXPOSURES

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COMPARING MUTUAL FUND RISK
EXPOSURES

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COMPARING MUTUAL FUND RISK
EXPOSURES

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