Arbitrage Pricing Theory

Knut P. Heen PhD

Associate Professor
Molde University College
Road Map
Based on HSG chapter 6
The Market Model (one factor)
Diversification
Multifactor Models
Tracking Portfolios
The Arbitrage Pricing Theory

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Why Factors Models?
Practical problems with the CAPM
Finding the tangency portfolio is difficult with more than two assets
Two assets → one covariance-term
Three assets → three covariance-terms
Four assets → six covariance-terms
Holding the market portfolio is not always optimal
Finding the portfolio which gives the best risk-return trade-off is not always
the goal
Saving for a house → portfolio which tracks the housing market
Pension fund → portfolio which matches the pension liabilities
We shall see that factor models may be helpful in these situations

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The Market Model (1)
An empirical model
Seeks to explain the future asset return as a function of the historical
relationship to one risk factor (the market return)
Run a regression of past asset returns on past market returns

Past returns are explained by two components

The loading (βi) on the risk factor (the market return, RM)
The regression residual, εi
RM and εi are uncorrelated by definition

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The Market Model (2)
Variance decomposition

Systematic risk: β-term

Unsystematic risk: ε-term
Regression R-squared: fraction of return due to market movement
High R2 – Asset return follows market return closely
Low R2 – Asset return largely independent from market return

Note
Correlation between ri and rj may only go through RM
εi cannot be correlated with εj

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Diversification
Firm-specific risk

is truly firm-specific risk

Firm specific risk “washes out” in large portfolios

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Diversification Example
Two assets
Suppose:

Three assets
Suppose:

N assets

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Multifactor Models (1)
Why multifactor models?
Correlated residuals (the εs) imply that a part of the “unsystematic risk”
really is systematic
The “unsystematic risk” is not diversifiable
If a single risk factor does not make the residuals uncorrelated
There must be additional risk factors which can explain the correlation
Hence, we must look for additional risk factors until the residuals are no
longer correlated (or uncorrelated “enough” to be satisfactory)

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Multifactor Models (2)
The multifactor regression model

Pro or con?
The model is agnostic about what the factors should be
Three approaches
Factor analysis
Macroeconomic variables
Firm characteristics

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Factor Analysis
Purely statistical procedure
Look for factors which “explain” past covariance in returns
Use the ones which explain the past better

Problem
The factors may not have any economic interpretation at all
How do we know that the factors will “explain” future covariance?
Data mining

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Macroeconomic Variables
Start with a large set of macro variables
Unemployment, inflation, oil price etc.
Find the ones which explain past returns better

Problem
Hard to measure unanticipated changes in the variables
Anticipated changes cannot be a risk factor (why?)
Data mining

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Firm Characteristics
Start with a large set of firm characteristics
Firm size, book-to-market, growth etc.
Find the ones which explain the past better

Problem
Why would firm characteristics explain return at all?
Past mispricing (tech bubble)?
Data mining

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Factor Betas
The factor beta measures how sensitive the return of
the asset is to this particular risk factor
Oil price factor example
An oil company will have a large oil price beta
Facebook will have a near zero oil price beta

The standard portfolio math applies

(typo in book page 175)

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Factor Models
Computing covariance (uncorrelated factors)

Computing variance (uncorrelated factors)

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Portfolio Design
Tracking portfolios
Factor models allow us to design a portfolio such that it tracks another
asset (for example the housing market)

How?
Find the relevant risk factors
Determine factor betas for each asset
Construct portfolio such that the portfolio’s factor betas equal the
target asset’s factor betas

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Portfolio Design Example
Target asset
Suppose three factors and target asset beta-vector

Tracking portfolio
Three assets with weights

See example 6.5

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Pure Factor Portfolios
A pure factor portfolio is a portfolio with one factor
beta equal to one (the rest are zero)
Pure F1-portfolio

Application
May construct one pure factor portfolio for each factor
The expected return on the pure factor portfolio tells us the risk
premium for this particular risk factor
The pure factor portfolios may also be viewed as the ultimate building
blocks for all other tracking portfolios

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Tracking & Arbitrage (1)
The pure factor portfolios tell us the risk premium
offered for each factor
Gives us a menu of risk factors with corresponding risk premiums λ

Any asset or portfolio may be tracked by a linear

combination of the pure factor portfolios (and the
risk-free asset)
A target asset with factor-beta-vector may be tracked by buying 0.5 of
PFP1, 2 of PFP2, and selling 0.5 of PFP3
Risk-free weight:

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Tracking & Arbitrage (2)
If the pure factor portfolios consist of many assets, all
firm specific risks will be diversified away in the PFPs
We may therefore track all investments without firm-
specific risks perfectly
The tracking portfolio and the target asset must
therefore give exactly the same return (otherwise
there is an arbitrage opportunity)

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The Arbitrage Pricing Theory
Four assumptions
Returns described by a factor model
No arbitrage opportunities
Large number of securities (diversification, no firm-specific risk)
Frictionless financial markets

Conclusion

The only remaining problem is to find the correct factors

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