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Arbitrage Pricing Theory (APT)

Arbitrage pricing theory (APT) is an alternative to the capital asset pricing model (CAPM). Stephen Ross developed the theory in 1976. It is a well-known method of estimating the price of an asset. The theory assumes an asset's return is dependent on various macroeconomic, market and securityspecific factors. The APT formula is:

Re = Rf + B1Rp1 + B2Rp2 + B3Rp3 + BiRpi

Where: Re = the asset's expected rate of return Rf = the risk-free rate Bi = the sensitivity of the asset's return to the particular factor Rpi = the risk premium associated with the particular factor The general idea behind APT is that two things can explain the expected return on a financial asset: one is a security specific factor and the other is the security's sensitivity to that factors. This relationship takes the form of the linear regression formula above. There are an infinite number of security-specific factors for any given security including inflation, production measures, investor confidence, exchange rates, market indices or changes in interest rates. It is up to the analyst to decide which influences are relevant to the asset being analyzed. Once the analyst derives the asset's expected rate of return from the APT model, he or she can determine what the "correct" price of the asset should be by plugging the rate into a discounted cash flow model. Note that APT can be applied to portfolios as well as individual securities. After all, a portfolio can have exposures and sensitivities to certain kinds of risk factors as well. Advantages and Disadvantages: The APT was a revolutionary model because it allows the user to adapt the model to the security being analyzed. And as with other pricing models, it helps the user decide whether a security is undervalued or overvalued and so he or she can profit from this information. APT is also very useful for building portfolios because it allows managers to test whether their portfolios are exposed to certain factors. APT may be more customizable than CAPM, but it is also more difficult to apply because determining which factors influence a stock or portfolio takes a considerable amount of research. It can be virtually impossible to detect every influential factor and to determine how much sensitive the security is to a particular factor. But getting "close enough" is often good enough; in fact studies find that four or five factors will usually explain most of a security's return: Inflation, GNP, investor confidence and shifts in the yield curve.

Fama-French Three Factor Model

The Fama-French Three Factor Model is a method used by finance professionals to explain the risk and return of equity portfolios. The Three Factor Model compares a portfolio to three distinct risks found in the equity market to assist in decomposing returns. Before the Three Factor Model, there was the Capital Asset Pricing Model (CAPM), a single factor way to explain portfolio returns. After testing CAPM on thousands of portfolios, Eugene Fama and Ken French found that on average, a portfolios beta explains about 70% of its actual returns but 30% are dependent on other factors. Explaining 70% of a portfolio's return using CAPM is fine, but Fama and French thought they could do better. They designed a more elaborate model that uses three risk factors. In the Fama-French Three Factor model, beta is still the most important risk factor because it still accounts for 70% of the typical diversified portfolio return. However, the size of the stocks in a portfolio and the price-to-book value of the stocks made significant differences. Size is the second risk factor in the Three Factor Model. This factor compares the weighted average market value of the stocks in a portfolio to the weighted average market value of stocks on the market. Small stocks tend to act very differently than big stocks in almost all market conditions. In the long run, small stocks have generated higher returns than large stocks, although the extra return is not free. There is more risk in small stocks. Fama and French call size risk a different yet important factor in portfolio returns. The third factor compares the amount of value stock exposure in relation to the market. Value stocks are companies that tend to have lower earnings growth rates, higher dividends, and higher book value compared to price (BTM). Fama-French measured the performance of high BTM stocks (value stocks) against low BTM stock (growth stocks) and found that these two stocks act very differently. In the long run, value stocks have generated higher returns than growth stocks, although because value stocks have higher risk. Fama-French tested thousands of random stock portfolios against their model and found that a combination of beta, size, and value explained 95% of a diversified portfolios return. In other words, when analyzing the returns of a diversified stock portfolio against the stock market, 95% of the return could be explained by the portfolios sensitivity to the market (beta), the size of stocks in the portfolio (size), and the book -to-market (BTM). The Fama-French Three Factor Model was far better than the 70% explanatory power of beta alone using CAPM.