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Factor Models
Objective: Introduce the concept
of multifactor models used in APT
chapter 10
Multifactor model:
Suppose the two most important macroeconomic sources of risk are uncertainties surrounding the
state of the business cycle, news of which we will again measure by unanticipated growth in GDP
and changes in interest rates. We will denote by IR any unexpected change in interest rates. The
return on any stock will respond both to sources of macro risk and to its own firm-specific influences

Single factor model

ri = E (ri ) + i F + ei

E(ri) = alpha

ri = Return for security i

= Factor sensitivity or factor loading or factor beta
F = Surprise in macro-economic factor
(F could be positive, negative or zero)
ei = Firm specific events
F the deviation of the common factor from its expected value

Returns on a security come from two sources

Common macro-economic factor
Firm specific events

EX: the performance of the airline is very sensitive to economic activity but is less sensitive to
interest rates. It will have a high GDP beta and a lower interest rate beta.

Multifactor model
ri = Return for security i
= Factor sensitivity for GDP
= Factor sensitivity for Interest Rate
ei = Firm specific events
Multifactor SML:

a two-factor model describing the excess return on stock i

RPGDP = Risk premium for GDP

RPIR = Risk premium for Interest Rate

Arbitrage pricing
model
Objective: Introduce the concept
of arbitrage pricing and
comparison of APT to CAPM

Arbitrage

Def.: The exploitation of

security mispricing in
such a way that riskfree economic profits
can be earned.
It involves the
simultaneous purchase
and sale of securities.

Equilibrium market
prices rule out risk-free
arbitrage opportunities.
Strategy: Zero
investment portfolio
with sure profit in at
least one state and no
loss in any state of
nature.

A portfolio of zero net value established by buying and shorting component securities, usually in
the context of an arbitrage strategy.
A zero-investment portfolio has the advantages of carrying little or no risk and reducing taxes.
Obviously, however, there is little or no return on a zero-investment portfolio.
To give a very simple example, suppose one buys 100 shares in AT&T while simultaneously
selling 100 shares; this creates a zero-investment portfolio

Example

A portfolio consisting of a
long position in stock C and
a short position in stock A
and B
requires zero investment
produces non-negative
returns in all scenarios
and positive returns in
some scenarios.

Stock
A
B
C
C-(A+B)

everybody want to borrow A and B, cheaper and cheaper

Price
$5
$15
$20

Scenario
I
$7
$1
$10

Profit
II
III
$10 $2
$10 $3
$20 $8

$0

$2

$0 $3

APT (Ross 1976)

Security returns can be described by a factor

model.

There are sufficient securities to diversify away

idiosyncratic risk.

Well-functioning security markets do not allow

for the persistence of arbitrage opportunities.

One factor APT (Ross 1976)

Firm-specific and macro-factor

ri = E (ri ) + i F + ei
E(F)=0
i sensitivity of firm i to F
ei firm specific disturbance
Example:
F = unexpected GDP
i = Sensitivity of i to F

Consider a well-diversified
portfolio (ep =0)

rp = E (rp ) + p F + e p
with
N

p = wi i

Why?
Hint:

i =1

e p = wi ei
i =1

p2 = p2 F2 + 2 (e p )
(e p ) = w2 2 (ei )
N

i =1

Betas and expected return

Idiosyncratic risk can be

diversified away.
Only factor risk commands a
risk-premium.

short B

r
A
B
10%
8%
/= 1.0
Arbitrage portfolio:
(0.10 + 1.0 x F) x $1m long A
- (0.08 + 1.0 x F) x $1m short B
0.02 x $1m = $20,000 profit

The Security Market Line

(SML)

(1)

The SML derived with a one

factor APT model is identical to
CAPM:

E (rp ) = rf + p (E (rm ) rf )

APT does not require a

market portfolio on the
efficient frontier.

r
E(rm)

M
E(rm-rf)

rf

Betas and expected return

How about portfolios with

different betas?
Risk premium must be
proportional to beta!

r
x

= w + w
A
B
=
B = 0
+
B A
B A

rf

E (rZ ) = w E (rA ) + w E (rB )

=

From (1)

B A

E (rA ) rf

E (rA ) +

A
E (rB ) = rf
B A

E (rB ) rf

WA + WB = 1
WA x beta B + WA x beta A = 0

our purpose try to construct

Example 1

Consider the following one

factor economy. All
portfolios are well
diversified:
Portfolio E(r ) Beta
A
12% 1.2
F
6%
0

Suppose that another

portfolio, E, has a beta of
0.6 and expected return of
8%.
Would an arbitrage
opportunity exist? What
would be the strategy?

Example 1

Consider the following one

factor economy. All
portfolios are well
diversified:
Portfolio E(r ) Beta
A
12% 1.2
F
6%
0

xem lai

E(rA ) = 6% + 1.2*RP = 12%

So RP = 5%
E(rE ) = 6% + 0.6*5% = 9%

Construct portfolio Q with 50%

of $W in portfolio A and 50% of
$W in risk-free asset F.

Suppose that another

portfolio, E, has a beta of
0.6 and expected return of
Long $W of the portfolio Q and
8%.
short $W of portfolio E
Would an arbitrage
$W*9% - $W*8% = 0.01$W
opportunity exist? What beta Q = beta A x 0.5 + beta T x 0.5
would be the strategy?
= 1.2 x 0.5 + 0 x 0.5 = 0.6

Example 2

Consider the following two factor economy. All portfolios

are well diversified:
Portfolio
A
F1
F2
rf

E(r ) Beta1 Beta2

12% 0.5
0.75
10%
1
0
12%
0
1
0
4%
0

Would an arbitrage opportunity exist? What would be

the strategy?

E(rA ) = 4% + 0.5(10% - 4%) + 0.75(12% - 4%) = 13%

Construct portfolio B by putting 50% wealth on F1 and

75% wealth on F2 and -25% on risk-free asset; Long $W
of portfolio B and short $W of portfolio A
borrow
W* E(rB ) W* E(rA ) = W*(13%-12%) = 0.01W
long (buy)

short (sell)

CAPM and APT Compared

CAPM requires the benchmark portfolio in the SML

be the true market portfolio; while a well-diversified
portfolio can serve the benchmark portfolio in APT.
APT applies to well diversified portfolios and most of
individual stocks; while CAMP applies to every stock.
APT can be extended to multifactor models.
A violation of APT cause a strong pressure to restore
even if only a limited number of investors become
aware of the disequilibrium; while a violation of the
relationship specified by the CAPM needs many
investors to tilt a small position in their portfolios to
restore the equilibrium.

Fama-French three-factor
model

The factors chosen are variables that on past

evidence seem to predict average returns
well and may capture the risk premiums

rit =
i + iM RMt + iSMB SMBt + iHML HMLt + 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

A brief introduction to
linear regression
A review of linear regression
analysis to help you interpret the
regression output of MS-Excel

Simple and multiple linear

regression (SLR, MLR)
There exist parameters 0, 1, (j,), and 2 such that for any
fixed value of the independent vector of variable(s) X, the
dependent variable, Y, is related to X through the model
equation :
n

Y = 0 + 1 X 1 (+ j X j ) +
j =2

For the equation to hold an error term needs to be

appended to the model equation for each observation (Y,X)
is a random variable with E()=0 and V()=2.
Note that for individual observations i i is unlikely to be
zero.

A simple linear regression

example

Regression example
12
10
8
6
4
2
0
-2
-4

y(true)
y(obs.)
y(est.)

10

15

20

25

The pink dots are the observations (Y,X). The solid line
represents the estimated relationship between Y and X.
The dotted line describes the true (unobservable) relationship
between Y and X.

Excel regression output

The regression output
has three segments:

Overall regression
statistics
ANOVA Analysis of
Variance
Parameter estimates

Regression statistics
R2 how much of the
variation in the dependent
variable is explained by the
variation in the independent
variable(s).
Multiple R square root of
the R2.
Adjusted R2 R2 corrected
for degrees of freedom
used in regression.

2
adj

n 1 SSE (n 1)R 2 k
=1
=
n (k + 1) SST
n 1 k

ANOVA Analysis of Variance (2)

df degrees of freedom
SS sum of squares
SST = ( y i y ) = y i2
2

( y )

/n

SSR Regression sum of

squares SSR=SST-SSE
SSE Sum of squared
errors

Regression estimates

One row for each independent variable and the

intercept.
Standard error Standard error of the coefficient
estimate.

t-stat: Significance is asymptotically normal. t =

P-value: Probability that the coefficient is not statistically

different from zero.
Lower- Upper: Confidence interval for (1-)

Confidence intervals for

point estimates
=graph!$A
4.5%
$3:$A$63
4.0%

~95%

->

3.0%
2.5%

2.0%

~68%

1.5%
1.0%
0.5%

(1 ) / 2

(1 ) / 2

0.0%

-3.1
-2.9
-2.7
-2.5
-2.3
-2.1
-1.9
-1.7
-1.5
-1.3
-1.1
-0.8
-0.6
-0.4
-0.2
-0
0.15
0.35
0.55
0.75
0.95
1.15
1.35
1.55
1.75
1.95
2.15
2.35
2.55
2.75
2.95

Probability density

3.5%

Deviation from mean in standard errors

Critical t-values

The student-t distribution asymptotically approaches

the standard normal distribution. This means for
large samples (larger than 150) t and z distributions
are the same. For smaller sample sizes the critical tvalues are larger than the critical z-values for the
same level of significance.
Standard levels of confidence are 90%, 95%, and
99% (a 0.1, 0.05, and 0.01). As a rule of thumb, if a
table of t-values or information about the df is absent
t-coefficients larger than two are often considered
significant.

Confidence interval

A 100(1-)% confidence interval for a coefficient

(slope) estimate of the true regression line is:

[ t
1

/ 2 , df

1 1 + t / 2,df
1

/2 indicates that this is a two tailed test rather than

a one-tailed test
df is the residual degrees of freedom from the
regression.

Example:
Influential data points - Outliers

Example: Confidence interval

What is the 95% confidence interval for the
coefficient of variable x in the influential data point
example regression?

Example: Confidence interval

What is the 95% confidence interval for the
coefficient of variable x in the example
regression?
What we need:

Coefficient estimate
Standard error
Critical t (df, desired C.I, one- or two-tailed)

Determining the critical t

One- or two-tailed: choose first or second row

Desired confidence level is (1-) choose column
Number of observations in your dataset determines the
row.
Intersection of chosen column and row holds the critical t.

Example: Confidence interval

Variables:
Coefficient estimate 0.241759
Standard error 0.121476
Critical t 2.228 (from table) 2.201 (exact)

Plug variables into formula:

[ t
1

/ 2 , df

1 1 + t / 2,df =
1

[0.2418 2.201x0.1215 1 0.2418 + 2.201x0.1215] =

[ 0.0256 1 0.5092]

Regression in
MS-Excel

Objective: Demonstrate
regression analysis in Excel and
interpret the results

Significance and confidence

intervals

95% confidence
interval: t2

x tcrit x x + tcrit

Coeff: point estimate

Std. error: Standard
deviation of point
estimate

t-stat.: How many

stdev is x away from
zero.
P-value: What is the
likelihood that true x
is not in CI
Upper/lower 95%:
Confidence Interval