CHAPTER 10 ARBITRAGE PRICING THEORY AND MULTIFACTOR MODELS OF RISK AND RETURN

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Outline of the Chapter

Arbitrage Pricing Theory
Arbitrage Single factor APT The Security Market Lines

Compare APT and CAPM Multifactor Models

Multifactor APT

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Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT) was developed by Ross (1976). APT predicts a security market line as CAPM and shows a linear relation with expected return and risk. According to APT: Security returns are described by a factor model There are sufficient securities to diversify away idiosyncratic risk Well-functioning security markets do not allow for the persistance of arbitrage opportunities

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Arbitrage Pricing Theory

An arbitrage opportunity arises when an investor can earn riskless profits without making a net investment. The law of one price states that if two assets are equivalent in all economically relevant respects, then they should have the same market price. Otherwise there is a chance for arbitrage activity simultaneously buying the asset where it is cheap and selling where it is expensive. During the arbitrage activity, investors will bid up the price where it is low and force it down where it is expensive. As a result they eliminate the arbitrage opportunities. Security prices should satisfy a no-arbitrage condition.

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Arbitrage Pricing Theory (Continued)

In a well-diversified portfolio nonsystematic risk across firms cancels out. Thus only factor risk (systematic risk of the portfolio) affects the risk premium on the security in market equilibrium.

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Arbitrage Pricing Theory (Continued)

The solid line indicates a well diversified portfolio, A with an expected return of 10% and A=1. The dahsed line also indicates a well diversified portfolio , B, with an expected return of 8% and B=1. Could they coexisted? Arbitrage opportunity Well-diversified portfolios with equal betas must have equal expected returns in market equilibrium. 10-6

Arbitrage Pricing Theory (Continued)

The

risk-premiums of welldiversified portfolios with different betas should be proportional to their betas. The risk premium (difference between the expected return on the portfolio and the risk-free rate) increases in direct proportion to . The expected return on all well-diversified portfolios must lie on the straight line from the risk-free asset. The equation of the line will also show the expected return on all well-diversified 10-7 portfolios.

Arbitrage Pricing Theory (Continued)

Take M, market index portfolio as a welldiversified portfolio. Since M is welldiversified, should be on the line and its beta is 1. Thus, the equation of the line is:

E(rP ) rf [ E(rM ) rf ] P
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Arbitrage Pricing Theory (Continued)

The no-arbitrage condition leads us to the equation that shows an expected return-beta relationship, which is identical to that of the CAPM. There are only three assumptions employed this time to obtain the same relationship as CAPM:
A factor model describing security returns A sufficient number of securities to form welldiversified portfolios Absence of arbitrage opportunities

This approach under new assumptions is called Arbitrage Pricing Theory.

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Arbitrage Pricing Theory (Continued) In addition,

APT does not require the benchmark portfolio on SML to be the true market portfolio. Thus, the problems related to have an unobservable market portfolio in CAPM are not problems in APT. Also, the index portfolio can easily be employed as a benchmark portfolio since it is well-diversified in APT even though it is not true market portfolio.
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Individual Assets and the APT Remember:

Imposing no-arbitrage condition on a singlefactor security market implies maintenance of the expected return-beta relationship for all well-diversified portfolios and for all but possibly a small number of individual securities.

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Individual Assets and the APT (Continued)

APT vs CAPM
APT applies to well diversified portfolios and not necessarily to individual stocks. APT gives a benchmark rate of return to be employed in capital budgeting, security valuation, or investment performance evaluation such as CAPM. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio.
Although CAPM holds even for securities, with APT it is possible for some individual stocks to be mispriced not lie on the SML.
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Multifactor Models: An Overview

Factor models are employed to describe and quantify the different factors that affect the rate of return on a security. In multifactor models stocks exhibit different sensitivities to the different components of systematic risk. Two-factor Model:
Suppose there are two most important macroeconomic sources of risk are:
Uncertainties surrounding the state of the business cycle (unanticipated growth in GDP) Unexpected changes in interest rates
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Multifactor Models: An Overview (Continued)

ri E(ri ) iGDPGDP iIRIR ei

Factor sensitivities (loadings, betas): measure the sensitivity of the security returns to the systematic factors. By using these mutifactor models different responses of the securities to varying sources of macro economy are captured. The question is where E(r) comes from? Security Market Line of CAPM: shows the relationship between expected return and the asset risk This time we have more than one risk factors.
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Multifactor Models: An Overview (Continued)

Based on the same idea with CAPMs SML we can say that in the two factor model the expected rate of return on a security will be the sum of:
The risk-free rate of return The sensitivity to GDP risk (GDP beta) *the risk premium for bearing GDP risk The sensitivity to interest rate risk (interest rate beta) *the risk premium for bearing interest rate risk

E (r ) rf GDP RP GDP IR RP IR
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A Multifactor APT
Factor Portfolios: A well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of zero on any other factor.
Returns on factor portfolios are correlated to one source of risk but totally uncorrelated with the other sources of risk.

E (rA ) rf AF 1 RPF 1 AF 2 RPF 2

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Where Should We Look for Factors? The mutlifactor APT does not say anything about the determination of relevant risk factors and their risk premiums. Still we want to narrow the set:
Limit ourselves to the systematic factors with considerable ability to explain security returns Choose factors that seem likely to be important risk factors

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Where Should We Look for Factors? (Continued)

Chen, Roll and Ross (1986)
% change in industrial production, % change in expected inflation, % change in unanticipated inflation, excess return of long-term corporate bonds over long-term government bonds, and excess return of long-term government bonds over T-bills.

rit i iIPIP t iEI EI t iUIUIt iCGCGt iGBGB t eit

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Where Should We Look for Factors? (Continued)

Fama and French three-factor model (1996)
They use firm characteristices to capture the effects of systematic risk. They expect that the firm-specific variables proxy for yet-unknown more fundamental variables.

rit i iM RMt iSMBSMB t iHMLHML t eit

where: SMB = Small Minus Big, i.e., the return of a portfolio of small stocks in excess of the return on a portfolio of large stocks HML = High Minus Low, i.e., the return of a portfolio of stocks with a high book to-market ratio in excess of the return on a portfolio of stocks with a low book-to-market ratio
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