CHAPTER 10

Arbitrage Pricing
Theory and
Multifactor
Models of Risk
and Return

Investments, 8th edition

Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All

Single Factor Model

Returns on a security come from two sources
Common macro-economic factor
Firm 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

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Multifactor Models
Use more than one factor in addition to
market return
Examples include gross domestic product,
expected inflation, interest rates etc.
Estimate a beta or factor loading for each
factor using multiple regression.

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Multifactor Model Equation

ri = E(ri) + iGDP GDP + iIR IR + ei
ri

= Return for security i

i GDP= Factor sensitivity for GDP

i = Factor sensitivity for Interest Rate
IR

ei

= Firm specific events

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Multifactor SML Models

E(r) = rf + iGDPRPGDP +

IRi RPIR

GDP
= Factor sensitivity for GDP
i
RPGDP = Risk premium for GDP

i IR = Factor sensitivity for Interest Rate

RPIR = Risk premium for Interest Rate

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Arbitrage Pricing Theory

Arbitrage - arises if an investor can construct a
zero investment portfolio with a sure profit
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

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APT & Well-Diversified Portfolios

rP = E (rP) + PF + eP
F = some factor
For a well-diversified portfolio:
eP approaches zero
Similar to CAPM,

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Figure 10.1 Returns as a Function of the

Systematic Factor

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Figure 10.2 Returns as a Function of the

Systematic Factor: An Arbitrage
Opportunity

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Figure 10.3 An Arbitrage Opportunity

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Figure 10.4 The Security Market Line

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APT and CAPM Compared

APT applies to well diversified portfolios and
not necessarily to individual stocks
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML
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

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Multifactor APT
Use of more than a single factor
Requires formation of factor portfolios
What factors?
Factors that are important to performance
of the general economy
Fama-French Three Factor Model

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Two-Factor Model

ri E (ri ) i1 F1 i 2 F2 ei
The multifactor APR is similar to the onefactor case
But need to think in terms of a factor portfolio
Well-diversified
Beta of 1 for one factor
Beta of 0 for any other

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Example of the Multifactor Approach

Work of Chen, Roll, and Ross
Chose a set of factors based on the ability
of the factors to paint a broad picture of the
macro-economy

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Another Example:
Fama-French
Three-Factor
The
factors chosen
are variables Model
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

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