CHAPTER TWELVE

ARBITRAGE PRICING
THEORY

1
 Background

• Estimating expected return with the Asset

Pricing Models of Modern Finance
– CAPM
• Strong assumption - strong prediction

2
 Market Index on Efficient Set Corresponding Security Market
Line

Expected Expected
B
Return Return
C
x x
x xx
Market x
x xx
Index x
x x
x
x xx
A x
x xx
x
x xx

Risk Market
(Return Variability) Beta
 Market Index Inside Efficient Corresponding Security Market
Set Cloud

Expected Expected
Return Return

Market
Index

Risk Market Beta

(Return Variability)
 FACTOR MODELS

• ARBITRAGE PRICING THEORY (APT)

– is an equilibrium factor model of security returns
– Principle of Arbitrage
• the earning of riskless profit by taking advantage of
differentiated pricing for the same physical asset or security
– Arbitrage Portfolio
• requires no additional investor funds
• no factor sensitivity
• has positive expected returns
– Example …
5
Curved Relationship Between Expected Return and Interest Rate Beta

Expected Return

35%

E F
D
25%

C
15%

B
A
5%

-3 -1 -5% 1 3
Interest Rate Beta

-15%
 The Arbitrage Pricing Theory

• Two stocks
 A: E(r) = 4%; Interest-rate beta = -2.20
 B: E(r) = 26%; Interest-rate beta = 1.83
 Invest 54.54% in E and 45.46% in A
 Portfolio E(r) = .5454 * 26% + .4546 * 4% = 16%
 Portfolio beta = .5454 * 1.83 + .4546 * -2.20 = 0
 With many combinations like this, you can create a
risk-free portfolio with a 16% expected return.
 The Arbitrage Pricing Theory

• Two different stocks

 C: E(r) = 15%; Interest-rate beta = -1.00
 D: E(r) = 25%; Interest-rate beta = 1.00
 Invest 50.00% in E and 50.00% in A
 Portfolio E(r) = .5000 * 25% + .4546 * 15% = 20%
 Portfolio beta = .5000 * 1.00 + .5000 * -1.00 = 0
 With many combinations like this, you can create a risk-
free portfolio with a 20% expected return. Then sell-short
the 16% and invest the proceeds in the 20% to arbitrage.
 The Arbitrage Pricing Theory

• No-arbitrage condition for asset pricing

 If risk-return relationship is non-linear, you
can arbitrage.
 Attempts to arbitrage will force linearity in
relationship between risk and return.

9
 APT Relationship Between Expected Return and Interest Rate Beta

Expected Return
35%
F
E
25% D

15%

C
5%

A B
-3 -1 -5% 1 3
Interest Rate Beta

-15%
 FACTOR MODELS

• ARBITRAGE PRICING THEORY (APT)

– Three Major Assumptions:
• capital markets are perfectly competitive
• investors always prefer more to less wealth
• price-generating process is a K factor model

11
 FACTOR MODELS
• MULTIPLE-FACTOR MODELS
– FORMULA

ri = ai + bi1 F1 + bi2 F2 +. . .
+ biKF K+ ei
where r is the return on security i
b is the coefficient of the factor
F is the factor
e is the error term

12
 FACTOR MODELS

• SECURITY PRICING
FORMULA:
ri = 0 + 1 b1 + 2 b2 +. . .+ KbK
where
ri = rRF +(1rRFbi12rRF)bi2+
rRFbiK
13
 FACTOR MODELS

where r is the return on security i

is the risk free rate
b is the factor
e is the error term

14
 FACTOR MODELS

• hence
– a stock’s expected return is equal to the risk
free rate plus k risk premiums based on the
stock’s sensitivities to the k factors

15