Investment Analysis & Portfolio Management

Chapter 10

Arbitrage Pricing Theory and Multifactor Models of Risk and Return

FIN 435 (Instructor- Saif Rahman)

Single Factor Model

Returns on a security come from two sources

Common
Firm

macro-economic factor

specific events

Possible common macro-economic factors

Gross

Domestic Product Growth

Interest

Rates
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Single Factor Model Equation

ri E (ri ) i F ei
ri = Return for security I

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

FIN 435 (Instructor- Saif Rahman)

Multifactor Models
Use

more than one factor in addition to market return

include gross domestic product, expected

Examples

inflation, interest rates etc.

Estimate

a beta or factor loading for each factor

using multiple regression.

FIN 435 (Instructor- Saif Rahman)

Multifactor Model Equation

ri = E(ri) + i GDP GDP + i IR IR + ei
ri = Return for security i

i GDP= Factor sensitivity for GDP

i IR = Factor sensitivity for Interest Rate

ei = Firm specific events

FIN 435 (Instructor- Saif Rahman)

Arbitrage Pricing Theory

Arbitrage - arises if an investor can construct a zero investment portfolio with a sure profit. Risk-less profit with zero initial outlay or investment. Since no investment is required, an investor can create large positions to secure large levels of profit. In efficient markets, profitable arbitrage opportunities will quickly disappear. Example the same product is being transacted in two shops. The price in Shop A is Tk. 20 whereas in Shop B, the price is Tk. 22. Assume buying and selling prices are same. What will happen? How can you make risk-less profit with no initial outlay or investment? How will this arbitrage opportunity disappear in an efficient market? FIN 435 (Instructor- Saif Rahman) The Law of One Price

Arbitrage Price Theory

The Arbitrage Pricing Theory (APT) is a relatively new theory
of expected asset returns due to Ross (1976). The APT explicitly accounts for multiple factors. The APT requires three assumptions: 1) Returns can be described by a factor model 2) There are no arbitrage opportunities 3) There are large numbers of securities that permit the formation of portfolios that diversify the firm-specific risk of individual stocks
FIN 435 (Instructor- Saif Rahman)

Arbitrage Price Theory

If

there are K factors, then the return generating process is:

ri = ai + i1F1 + i2F2 + . + iKFK + ei

The expected returns of each security will be a function of its factor s The model is derived by showing that for well diversified portfolios, if the portfolios expected return (price) is not equal to the expected return predicted by the portfolios s, then there will be an arbitrage opportunity

Note that fewer assumptions are necessary to derive the APT (than are necessary to derive the CAPM)
FIN 435 (Instructor- Saif Rahman)

Arbitrage Example
Current Stock Price$ A 10 B 10 C 10 D 10 Expected Return% 25.0 20 32.5 22.5 Standard Corr. Dev.% 29.58 AB -0.15 33.91 BC -0.87 48.15 AC -0.29 8.58

FIN 435 (Instructor- Saif Rahman)

Arbitrage Portfolio
Mean Portfolio A,B,C D
25.83

S.D.
6.40

22.25

8.58

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Arbitrage Action and Returns

E. Ret.
* P * D St.Dev.
Short 3 shares of D and buy 1 of A, B & C to form P. You earn a higher rate on the investment than you pay on the short sale.

FIN 435 (Instructor- Saif Rahman)

APT & Well-Diversified Portfolios

Based on the law of one price Does not rely on mean-variance assumption (as the CAPM does) It assumes that asset returns are linearly related to a set of indexes. Each index represents a factor that influences the return on an asset. rP = E (rP) + bPF + eP F = some factor For a well-diversified portfolio: eP approaches zero

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Comparing a Portfolio with an Individual Security

E(r)% E(r)%

F
Portfoli o

F Individual Security
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Disequilibrium Example
E(r)%
10 D 7 6 Risk Free 4 C A

.5

1.0

Beta for F

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Disequilibrium Example

Short Portfolio C Use funds to construct an equivalent risk higher return Portfolio D.

D is comprised of A & Risk-Free Asset

Arbitrage profit of 1%

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APT with Market Index Portfolio

E(r)%
M

[E(rM) - rf]

Risk Free

Market Risk Premium

1.0

Beta (Market Index)

FIN 435 (Instructor- Saif Rahman)

APT and CAPM Compared

The CAPM is a special case of APT that would result if the single common factor affecting all security returns was the return on the market portfolio. APT is more general, or robust, than the CAPM. It is based on less restrictive assumptions. APT does not identify either the number or the definition of the factors affecting returns. These have to be empirically determined by fitting a factor model to returns. The CAPM is a well-specified model, where the parameters of the model are spelled out up front. However, it relies on the Market Portfolio, which is in principle non measureable. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. APT can be extended to multifactor models.

FIN 435 (Instructor- Saif Rahman)

Arbitrage Price Theory

In

order to implement the APT we need to know what the factors are! Here the theory gives no guidance. There is some evidence that the following macroeconomic variables may be risk factors:
1)Changes in monthly GDP 2)Changes in the default risk premium 3)The slope of the yield curve 4)Unexpected changes in the price level

5)Changes in expected inflation Note that the difficulty of measuring expected inflation makes the estimation of 4 & 5 difficult
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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

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The Multifactor CAPM and the APM

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 APT is largely silent on where to look for priced sources of risk

FIN 435 (Instructor- Saif Rahman)