CHAPTER 10

A R BI T RAGE P R I CI NG T HEORY A N D
M ULT I FAC TOR MODE L S OF R I S K A N D R E T U RN
BODI E , Z. , A . KA N E , A N D A . MA RCU S , 2 0 0 9. I N V ESTM ENTS .
8 T H E DI T ION. N Y: M CG R AW -HIL L/I RWIN.
OUTLINE
Arbitrage:
The exploitation of security mispricing in such a way that risk-free profits can
be earned.
It involves the simultaneous purchase and sale of equivalent securities in
order to profit from discrepancies in their prices.
Basic principle of capital market theory
Equilibrium market prices are rational in that they rule out arbitrage
opportunities.
If actual security prices allow for arbitrage, the result will be strong
pressure to restore equilibrium.
Therefore, security markets ought to satisfy no-arbitrage condition.
OUTLINE
Multifactor models of security returns
These can be used to measure and manage exposure to each of many
economy-wide factors such as business-cycle risk, interest or inflation risk,
energy price risk, etc.
These models also lead us to a multifactor version of the security market line
in which risk premiums derive from exposure to multiple risk sources, each
with their own risk premium.
We show how factor models combined with a no-arbitrage condition
lead to a simple relationship between expected return and risk.
This approach to the risk-return trade-off is called Arbitrage Pricing Theory
or APT.
OUTLINE
We derive the APT and show why it implies a multifactor
security line, then ask what factors are likely to be the most
important sources of risk.
These will be the factors generating substantial hedging
demands that brought us to the multifactor CAPM.
Both the APT and CAPM therefore lead to multiple-risk
versions of the security market line, enriching the insights
we can derive about the risk-return relationship.
MULTIFACTOR MODELS OF SECURITY
RETURNS
Instead of using a market proxy summarizing the broad
impact of macro factors, we focus directly on the ultimate
sources of risk.
Factor models are thus tools that allow us to describe and
quantify the different factors that affect the ROR of a
security during any time period.
MULTIFACTOR MODELS OF SECURITY
RETURNS
The single-factor model is described by this equation:
𝑟 =𝐸 𝑟 +𝛽𝐹+𝑒
Suppose for instance that the macro factor, 𝐹, is the news about the
state of the business cycle, measured by the unexpected change in
GDP, and the consensus is that GDP will grow by 4%.
◦ If GDP grows by 3%, then the value of 𝐹 would be -1%
Estimating a single factor model, however, means we implicitly
impose an (incorrect) assumption that each stock has the same
relative sensitivity to each risk factor (when actually betas may
differ!).
MULTIFACTOR MODELS OF SECURITY
RETURNS
Consider, this time, a 2-factor model of the form:
𝑟 = 𝐸 𝑟 + 𝛽 𝐺𝐷𝑃 + 𝛽 𝐼𝑅 + 𝑒
Here, the two most important sources of macro risk are taken to be
uncertainties surrounding the state of the business cycle and any unexpected
change in interest rates.
The two macro factors comprise the systematic factors in the economy.
Both factors have zero expectation (i.e., they represent changes in these
variables that have not already been anticipated).
The coefficients of the factors, measuring the sensitivity of share returns to
that factor, are sometimes called factor sensitivities, factor loadings, or factor
betas.
Factor betas can provide a framework for a hedging strategy (i.e., can hedge a
source of risk by establishing an opposite factor exposure to offset that risk).
MULTIFACTOR SECURITY MARKET LINE
The multifactor model simply describes the factors that affect security returns
(i.e., where is no "theory" in the equation).
We therefore need a theoretical model of equilibrium security returns.
Previously, we developed one example of such a model: the SML of the CAPM.
The CAPM asserts that securities will be priced to give investors an expected
return comprised of the:
◦ Risk-free rate (compensation for time value of money)
◦ Risk premium (beta times the benchmark risk premium)
This gives the equation:
𝐸 𝑟 =𝑟 +𝛽 𝐸 𝑟 −𝑟
MULTIFACTOR SECURITY MARKET LINE
If we denote the risk premium of the market portfolio by 𝑅𝑃 , then a useful way to
write the above CAPM equation is:
𝐸 𝑟 = 𝑟 + 𝛽𝑅𝑃
A multifactor index model gives rise to a multifactor SML in which the risk premium
is determined by the exposure to each systematic risk factor, and by a risk premium
associated with each of those factors.
The 2-factor SML, for example, is:
𝐸 𝑟 =𝑟 +𝛽 𝑅𝑃 + 𝛽 𝑅𝑃
where 𝛽 denotes sensitivity to unexpected changes in GDP growth, and 𝑅𝑃 is the risk
premium  associated  with  “one  unit”  of  GDP  exposure (i.e., corresponding to a GDP beta of 1).
Similarly, 𝛽 denotes sensitivity to unexpected interest rate changes, while 𝑅𝑃 is the risk
premium  associated  with  “one  unit”  of  interest rate exposure.
MULTIFACTOR SECURITY MARKET LINE
2-factor SML: 𝐸 𝑟 = 𝑟 + 𝛽 𝑅𝑃 + 𝛽 𝑅𝑃
That is, the expected ROR on a security would the sum of:
◦ The risk-free return, 𝑟
◦ The GDP beta (sensitivity to GDP risk) times the risk premium for bearing GDP risk,
𝛽 𝑅𝑃
◦ The interest rate beta (sensitivity to the interest rate) times the risk premium for bearing
interest rate risk, 𝛽 𝑅𝑃

Note how the equation is a generalization of the simple SML except now there
are multiple risk sources, each with its own risk premium.
One important difference, however, is that a factor risk premium can be
negative in a multifactor economy (e.g., negative 𝑅𝑃 provided that interest
rates are not proxying for general economic activity).
ARBITRAGE PRICING THEORY
Developed by Stephen Ross in 1976
Like the CAPM, the APT predicts a security market line linking
expected returns to risk, but taking a different path to the SML
APT relies on 3 key propositions:
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.
ARBITRAGE, RISK ARBITRAGE, AND
EQUILIBRIUM
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.
This  “law”  is  enforced  by  arbitrageurs  (who  will  engage  in  arbitrage  
activity, buying the asset where it is cheap and selling where it is
expensive).
The idea that market prices will move to rule out arbitrage opportunities
is perhaps the most fundamental concept in capital market theory.
Security  prices  should  satisfy  a  “no-arbitrage  condition”  (i.e.,  a  
condition that rules out the existence of arbitrage opportunities).
ARBITRAGE, RISK ARBITRAGE, AND
EQUILIBRIUM
There is an important difference between arbitrage and risk-return dominance
arguments in support of equilibrium price relationships:
Dominance argument
When an equilibrium price relationship is violated, many investors will make
limited portfolio changes, depending on their degree of risk aversion.
Aggregation of these limited portfolio changes is required to create a large
volume of buying and selling, which in turn restores equilibrium prices.
Ex. CAPM, implying that all investors hold mean-variance efficient portfolios,
where if a security is mispriced, investors would tilt their portfolios toward
the underpriced and away from the overpriced securities (pressure on
equilibrium prices resulting from many investors shifting their portfolios,
each by a relatively small amount).
ARBITRAGE, RISK ARBITRAGE, AND
EQUILIBRIUM
Arbitrage
When arbitrage opportunities exist, each investor wants to take as large a
position as possible, hence it would not take many investors to bring about
price pressures necessary to restore equilibrium
Therefore, implications for prices derived from no-arbitrage arguments are
stronger than implications derived from a risk-return dominance argument
In the CAPM, the assumption that a large number of investors are mean-
variance sensitive is critical.
In contrast, in the APT, the implication of a no-arbitrage condition is that a few
investors who identify an arbitrage opportunity could mobilize large dollar
amounts and quickly restore equilibrium.
WELL-DIVERSIFIED PORTFOLIOS
We look now at the risk of a portfolio of stocks.
We first show that if a portfolio is well diversified, its firm-specific or
nonfactor risk becomes negligible, so that only factor (or systematic)
risk remains.
If we construct an 𝑛-stock portfolio with weights 𝑤 , ∑ 𝑤 = 1, then
the ROR on this portfolio is:
𝑟 =𝐸 𝑟 +𝛽 𝐹+𝑒
where
𝛽 = ∑𝑤 𝛽 ; 𝐸 𝑟 = ∑𝑤 𝐸 𝑟 ; 𝑒 = ∑𝑤 𝑒
WELL-DIVERSIFIED PORTFOLIOS
We can divide the variance of this portfolio into systematic and nonsystematic
sources:
𝜎 =𝛽 𝜎 +𝜎 𝑒
where 𝜎 is the variance of the factor 𝐹 and 𝜎 𝑒 is the nonsystematic risk of
the portfolio, given by 𝜎 𝑒 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 ∑ 𝑤 𝑒 = ∑ 𝑤 𝜎 𝑒 .
If the portfolio were equally weighted, 𝑤 = 1/𝑛, then the non-systematic
variance would be
1 1 𝜎 𝑒 1
𝜎 𝑒 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑤𝑒 = 𝜎 𝑒 = = 𝜎 𝑒
𝑛 𝑛 𝑛 𝑛

where the last term is the average value across securities of the non-systematic
variance.
WELL-DIVERSIFIED PORTFOLIOS
Therefore, when the portfolio gets large in the sense that 𝑛 is large, its
nonsystematic variance approaches zero (the effect of diversification).
We conclude that for the equally weighted portfolio, the nonsystematic (firm-
specific) variance approaches zero as 𝑛 become larger.
This property is true of portfolios other than the equally weighted one (i.e., any
portfolio for which 𝑤 approaches zero as 𝑛 increases).
A well-diversified portfolio is hence one that is diversified over a large enough
number of securities, with each weight small enough that for practical purposes
the nonsystematic variance is negligible.
Large (mostly institutional) investors can hold portfolios of hundreds and even
thousands of securities, thus the concept of well-diversified portfolios is clearly
operational in contemporary financial markets.
BETAS AND EXPECTED RETURNS
Because nonfactor risk can be diversified away, only factor risk
should command a risk premium in market equilibrium.
Nonsystematic risk across firms cancels out in well-diversified
portfolios (no reward for risk that can be eliminated).
Only the systematic risk of a portfolio of securities should be
related to its expected returns.
BETAS AND EXPECTED RETURNS
One can plot the return of a well-diversified portfolio 𝐴, with beta
equal to 1 and expected return equal to 10%, as follows:
𝑟 =𝐸 𝑟 + 𝛽 𝐹 = 10% + 1.0 × 𝐹 (linear equation)
In this case, nonsystematic risk is eliminated, and return is
completely determined by the systematic factor.
Now consider another well-diversified portfolio 𝐵, with an expected
return of 8% and beta of 1:
𝑟 = 𝐸 𝑟 + 𝛽 𝐹 = 8% + 1.0 × 𝐹
Could portfolios 𝐴 and 𝐵 coexist?
BETAS AND EXPECTED RETURNS
𝑟 =𝐸 𝑟 + 𝛽 𝐹 = 10% + 1.0 × 𝐹
𝑟 =𝐸 𝑟 + 𝛽 𝐹 = 8% + 1.0 × 𝐹
Could portfolios 𝐴 and 𝐵 coexist?
Clearly not , since no matter what the systematic factor turns out to be, 𝐴
outperforms 𝐵, leading to an arbitrage opportunity.
Can sell short 𝐵 and use proceeds to buy 𝐴, a zero net investment strategy,
and get a riskless payoff.
The profit is risk-free since the factor risk cancels out across the long and
short positions.
In short, well-diversified portfolios with equal betas must have equal expected
returns in market equilibrium, or arbitrage opportunities exist.
BETAS AND EXPECTED RETURNS
BETAS AND EXPECTED RETURNS
What about portfolios with different betas?
Quick answer: Their risk premiums must be proportional to beta
Consider a well-diversified portfolio 𝐶:
𝑟 = 6% + 0.5 × 𝐹
Now consider a new portfolio, 𝐷, composed of half of portfolio 𝐴 and half of
the risk-free asset (risk-free rate of 4%)
𝐷’s  beta  would  be:  .5 ∗ 0 + .5 ∗ 1.0 = .5
Its expected return would be: .5 ∗ 4 + .5 ∗ 10 = 7%
That is, 𝑟 = 7% + 0.5 × 𝐹
Now 𝐷 has an equal beta (= .5) but greater expected return than 𝐶 (7% >
6%), presenting an arbitrage opportunity.
BETAS AND EXPECTED RETURNS
We conclude that, to preclude arbitrage opportunities, the expected return
on all well-diversified portfolios must lie on the straight line from the risk-
free asset (in this example, 𝐶 cannot coexist with 𝐷)
In this case, risk premiums are indeed proportional to portfolio betas:
Portfolios 𝐴 (𝑟 = 10% + 1.0 × 𝐹) and portfolio 𝐷 (𝑟 = 7% + 0.5 × 𝐹)
are points on the line.
AN ARBITRAGE OPPORTUNITY
THE 1-FACTOR SECURITY MARKET LINE
Now consider the market index portfolio, 𝑀, as a well-diversified portfolio, and
let us measure the systematic factor as the unexpected return on that portfolio .
That is, 𝑟 = 𝐸 𝑟 + 𝛽 𝐹 = 𝐸 𝑟 + 1.0 × 𝐹
The index portfolio must also be on the line in the previous figure.
Since the beta of the index portfolio is 1, we can determine the equation
describing that line:
As the figure shows, the intercept is 𝑟 and the slope is 𝐸 𝑟 − 𝑟 , implying
that the equation of the line is:
𝐸 𝑟 =𝑟 + 𝐸 𝑟 −𝑟 𝛽
This implies an SML relation equivalent to the CAPM!
THE SECURITY MARKET LINE
THE 1-FACTOR SECURITY MARKET LINE
We have used the no-arbitrage condition to obtain an expected return-beta
relationship identical to the CAPM, without the restrictive assumptions of the
CAPM.
As noted this derivation depends on 3 assumptions:
A factor model describing security returns.
A sufficient number of securities to form well-diversified portfolios.
The absence of arbitrage opportunities (this last restriction the basis for the
name Arbitrage Pricing Theory).
Despite the less restrictive assumptions, the main conclusion of the CAPM,
namely the SML expected return-beta relationship, should at least be
approximately valid.
THE 1-FACTOR SECURITY MARKET LINE
Note that in contrast to the CAPM, the APT does not require
that the benchmark portfolio in the SML relationship be the
true market portfolio.
Any well-diversified portfolio may serve as the benchmark
portfolio.
Ex. One might define the benchmark portfolio as the well-
diversified portfolio most highly correlated with whatever
systematic factor is thought affect stock returns.
Accordingly, the APT has more flexibility than the CAPM because
problems associated with an unobservable market portfolio are not
a concern.
THE 1-FACTOR SECURITY MARKET LINE
In addition, the APT provides further justification for the use
of the index model in the practical implementation of the
SML relationship
Even if the index portfolio is not a precise proxy of the
true market portfolio, a cause of concern on the context of
the CAPM, we now know that if the index portfolio is
sufficiently well diversified, the SML relationship should
still hold true according to the APT.
APT AND THE CAPM: WHICH
DOMINATES?
But despite the advantages of the APT, it does not fully dominate the
CAPM.
The CAPM provides an unequivocal statement on the expected
return-beta relationship for all securities.
The APT implies that the expected return-beta relationship holds
for all save for a small number of securities.
Because the APT focuses on the no-arbitrage condition without
the further assumptions of the market or index model, the APT
cannot rule out a violation of the expected return-beta
relationship for any particular asset.
For this, we need the CAPM assumptions and its dominance
arguments.
A MULTIFACTOR APT
We can derive a multifactor version of the APT to accommodate multiple
sources of risk (aside from GDP surprise, these can be interest rate
fluctuations, inflation rates, oil prices, etc.)
Suppose that we generalize the single-factor model to a 2-factor model:
𝑟 =𝐸 𝑟 +𝛽 𝐹 +𝛽 𝐹 +𝑒
Factor 1, for example, may represent departure of GDP growth from
expectations.
Factor 2 may represent unanticipated changes in interest rates.
Each factor has zero expected value (because each measures the
surprise in the systematic variable rather than the level of the variable).
𝑒 also has zero expected value.
A MULTIFACTOR APT
Extending the model to any number of factors is straightforward.
Establishing a multifactor APT is similar to the one-factor case, but
first must introduce the concept of a factor portfolio (i.e., a well-
diversified portfolio constructed to have beta equal to 1 on one of
the factors and zero on any other factor).
A factor portfolio can thought of as a tracking portfolio, returns of which
track the evolution of particular sources of macroeconomic risk but are
uncorrelated with other risks.
It is possible to form such factor portfolios because we have a large number
of securities to choose from, and a relatively small number of factors.
Factor portfolios will serve as the benchmark portfolio for a multifactor
security market line.
MULTIFACTOR SML
Suppose that two factor portfolios, portfolios 1 and 2, have expected
returns of 10% and 12%, respectively, and that the risk-free rate is equal
to 4%.
The risk premium on the first factor is hence 6%, and on the second factor,
8%.
Now consider a well-diversified portfolio, 𝐴, with 𝛽 = .5 on the first
factor and 𝛽 = .75 on the second factor.
The APT states that the overall risk premium on portfolio 𝐴 must equal the
sum of risk premiums required as compensation for each source of
systematic risk:
𝐸 𝑟 −𝑟 =𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
MULTIFACTOR SML
𝐸 𝑟 −𝑟 =𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
The risk premium attributable to risk factor 𝑖 should be the portfolio's exposure
to factor 𝑖, 𝛽 , multiplied by the risk premium earned on the first factor
portfolio, 𝐸 𝑟 − 𝑟
Risk premium attributable to factor 1:
𝛽 𝐸 𝑟 − 𝑟 = .5 10% − 4% = .5 6% = 3%
Risk premium attributable to factor 2:
𝛽 𝐸 𝑟 − 𝑟 = .75 12% − 4% = .75 8% = 6%
Total risk premium on the portfolio should be 9% (= 3% + 6%).
Total return on the portfolio should be 13% (= 4% + 9%).
MULTIFACTOR SML
Note that the factor exposures for any portfolio, 𝑃, are given by its betas,
𝛽 and 𝛽 .
A competing portfolio, 𝑄, can be formed by investing in factor portfolios
with the following weights: 𝛽 in the first factor portfolio, 𝛽 in the
second factor portfolio, and 1 − 𝛽 − 𝛽 in T-bills.
By construction, 𝑄 will have betas equal to those of portfolio 𝑃 and
expected return of
𝐸 𝑟 =𝛽 𝐸 𝑟 +𝛽 𝐸 𝑟 + 1−𝛽 −𝛽 𝑟
=𝑟 +𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
MULTIFACTOR SML
Expected return of portfolio Q:
𝐸 𝑟 =𝛽 𝐸 𝑟 +𝛽 𝐸 𝑟 + 1−𝛽 −𝛽 𝑟
=𝑟 +𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
Using the example above,
𝐸 𝑟 =𝑟 +𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
= 4 + .5 × 10 − 4 + .75 × 12 − 4 = 13%
Because portfolio 𝑄 has precisely the same exposures as portfolio 𝐴 to the
two sources of risk, their expected returns ought to be equal.
Portfolio 𝐴 and 𝑄 ought to have an expected return of 13%.
If not, there would be an arbitrage opportunity.
MULTIFACTOR SML
We conclude that any well-diversified portfolio with betas 𝛽 and
𝛽 must have the return given by the above expected returns
equation otherwise arbitrage opportunities would open up, i.e.,
𝐸 𝑟 =𝑟 +𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
Note that the expected returns equation is simply a generalization of
the 1-factor SML and represents the multifactor SML for an economy
with multiple sources of risk:
𝐸 𝑟 =𝑟 +𝛽 𝐸 𝑟 −𝑟 +𝛽 𝐸 𝑟 −𝑟
One can also use this multifactor SML to compute for "fair" rates of
return.
WHERE TO LOOK FOR FACTORS?
A shortcoming of the multifactor APT is that it gives no guidance
concerning the determination of the relevant risk factors or their risk
premiums.
Two guiding principles:
We would want to limit the field to systematic factors with
considerable ability to explain security returns (since not good to
have too many explanatory variables).
We would want to choose factors that seem likely to be important
risk factors (i.e., those that concern investors sufficiently that they
will demand meaningful risk premiums to bear exposure to those
sources of risk).
MULTIFACTOR APPROACH
Ex. The multifactor approach of Chen, Roll, and Ross (1986), who
chose the following set of macro factors:
% change in industrial production
% change in expected inflation
% change in unanticipated inflation
Excess return of long-term corporate bonds over long-term
government bonds
Excess return of long-term government bonds over T-bills
MULTIFACTOR APPROACH
Their list gives rise to the following 5-factor model of security returns
during holding period 𝑡 as a function of the change in
macroeconomic indicators:
𝑟 = 𝛼 + 𝛽 𝐼𝑃 + 𝛽 𝐸𝐼 + 𝛽 𝑈𝐼 + 𝛽 𝐶𝐺 + 𝛽 𝐺𝐵 + 𝑒
This is a multidimensional security characteristic line (SCL) with
five factors.
Here, however, we estimate a multiple regression of the returns
of the stock in each period on the five macro factors.
The residual variance of the regression estimates the firm-specific
risk.
THE FAMA-FRENCH (FF) 3-FACTOR
MODEL
An alternative approach to specifying macroeconomic factors as
candidates for relevant sources of systematic risk uses firm
characteristics that seem to proxy for exposure to systematic risk.
The factors chosen are variables that on past evidence seem to
predict average returns well and therefore may be capturing risk
premiums.
THE FAMA-FRENCH (FF) 3-FACTOR
MODEL
An example of his approach is the Fama and French 3-factor model
(1996), which has come to dominate empirical research and industry
applications:
𝑟 =𝛼 +𝛽 𝑅 +𝛽 𝑆𝑀𝐵 + 𝛽 𝐻𝑀𝐿 + 𝑒
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)
THE FAMA-FRENCH (FF) 3-FACTOR
MODEL
In this model, the market index does play a role and is expected to
capture systematic risk originating from macroeconomic factors.
The two firm-characteristic variables above are chosen because of
long-standing observations that corporate capitalization (firm size)
and book-to-market ratio predict deviations of average stock returns
from levels consistent with the CAPM.
THE FAMA-FRENCH (FF) 3-FACTOR
MODEL
Fama and French justify this model on empirical grounds:
While SML and HML are not themselves obvious candidates for relevant risk
factors, the hope is that these variables proxy for yet-unknown more-
fundamental variables.
For instance, firms with high ratios of book-to-market value are more likely to
be in financial distress and that small stocks may be more sensitive to changes
in business conditions.
Thus, these variables may be capturing sensitivity to risk factors in the
macroeconomy.
THE FAMA-FRENCH (FF) 3-FACTOR
MODEL
The problem with empirical approaches such as the Fama-French model, which
uses proxies for extramarket sources of risk, is that none of the factors in the
proposed models can be clearly identified as hedging a significant source of
uncertainty.
Black (1993) points out that when researchers scan the database of security
returns  in  search  of  explanatory  factors  (i.e.,  engage  in  “data  snooping”),  they  
may  uncover  past  “patterns”  that  are  due  purely  to  chance.
◦ He observes how return premiums to factors such as firm size have proven to
be inconsistent.
However, Fama and French have shown that size and book-to-market ratios have
predicted average returns in various time periods and in markets all over the
world, thus mitigating potential effects of data snooping.
THE FAMA-FRENCH (FF) 3-FACTOR
MODEL
APT model or multi-index CAPM?
◦ The firm-characteristic basis of the Fama-French factors raises the question of
whether they reflect an APT model or an approximation to a multi-index
CAPM based on extra-market hedging demands.
◦ This is an important distinction for the debate over the proper interpretation
of the model, because the validity of the Fama-French-style models may
constitute either a deviation from rational equilibrium (as there is no rational
reason to prefer one or another of these firm characteristics per se), or that
firm characteristics identified as empirically associated with average returns
are correlated with other (yet unknown) risk factors.
This issue is still unresolved.
THE MULTIFACTOR CAPM AND THE APT
Multi-index CAPM:
Factors are derived from a multiperiod consideration of a stream
of consumption as well as randomly evolving investment.
opportunities pertaining to the distributions of rates of return.
Hence, hedge index portfolios must be derived from
considerations of the utility of consumption, nontraded assets, and
changes in investment opportunities.
Therefore, a multi-index CAPM will inherit its risk factors from
sources of risk that a broad group of investors deem important
enough to hedge.
THE MULTIFACTOR CAPM AND THE APT
Multi-index CAPM:
If hedging demands are common to many investors, the prices of
securities with desirable hedging characteristics will be bid up and
their expected return reduced.
This process requires a multifactor model to explain expected
returns, where each factor arises from a particular hedging motive.
Risk  sources  that  are  “priced”  in  market  equilibrium  (i.e.,  are  
sufficiently important to result in detectable risk premiums)
presumably will be systematic sources of uncertainty that affect
investors broadly.
THE MULTIFACTOR CAPM AND THE APT
APT
In contrast to the multi-index CAPM, the APT is largely silent on
where to look for priced sources of risk.
This lack of guidance is problematic, but by the same token, it
accommodates a less structured search for relevant risk factors.
These may reflect concerns of a broader set of investors, including
such institutions as endowment or pension funds that may be
concerned about exposures to risk that would not be obvious
from an examination of individual consumption/investment
decisions.
CONCEPT CHECK
(Single Factor Model) Suppose that macro factor 𝐹 is taken to be
news about the state of the business cycle, measured by the
unexpected percentage change in GDP. The consensus is that GDP
will increase by 4% this year. Suppose that a stock's beta value is 1.2.
◦ If GDP increases by just 3%, how would this translate in terms of
return on the stock?
◦ Suppose you currently expect the stock to earn a 10% return.
Then some macro news suggests that GDP growth will come in at
5% instead of 4%. How will you revise your estimate of the stock's
expected ROR?
CONCEPT CHECK
(Multifactor SML) Firm 𝐴 has a GDP beta of 1.2 and an interest beta
of -.3. Suppose the risk premium for one unit of exposure to GDP
risk is 6% while the risk premium for one unit of exposure to interest
rate is -7%. Suppose the risk-free rate is 4%.
◦ What is total expected return?
𝐸 𝑟 = 4% + 1.2 × 6% + −.3 × −.7
◦ Suppose the factor risk premiums were 𝑅𝑃 = 4% and 𝑅𝑃 =
− 2%. What would be the new value for the equilibrium expected
ROR on Firm 𝐴?
𝐸 𝑟 = 4% + 1.2 × 4% + −.3 × −.2
CONCEPT CHECK
Suppose the market index is a well-diversified portfolio with expected
return of 10% and that deviations of its return from expectation can serve
as the systematic factor (i.e. 𝑟 − 10%). The T-bill rate is 4%.
◦ From the SML equation, what would be the expected ROR on well-
diversified portfolio 𝐸 with a beta of 2/3?
◦ What if its expected return is actually 9%? Is there an arbitrage
opportunity? Explain.
◦ Now consider portfolio 𝐺, which is well diversified with beta of 1/3 and
expected return of 5%. Does an arbitrage opportunity exist? Explain.