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MODELS OF RISK AND RETURN

Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset.

The theory assumes an asset's return is dependent on various macroeconomic, market and

security-specific factors.

How it works/Example:

APT is an alternative to the capital asset pricing model (CAPM). Stephen Ross developed the

theory in 1976.

The APT formula is:

E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn

where:

E(rj) = the asset's expected rate of return

rf = the risk-free rate

bj = the sensitivity of the asset's return to the particular factor

RP = the risk premium associated with the particular factor

The general idea behind APT is that two things can explain the expected return on a financial

asset: 1) macroeconomic/security-specific influences and 2) the asset's sensitivity to those

influences. This relationship takes the form of the linear regression formula above.

There are an infinite number of security-specific influences for any given security including

inflation, production measures, investor confidence, exchange rates, market indices or

changes in interest rates. It is up to the analyst to decide which influences are relevant to the

asset being analyzed.

Once the analyst derives the asset's expected rate of return from the APT model, he or she can

determine what the "correct" price of the asset should be by plugging the rate into a

discounted cash flow model.

Note that APT can be applied to portfolios as well as individual securities. After all, a

portfolio can have exposures and sensitivities to certain kinds of risk factors as well.

Why it Matters:

The APT was a revolutionary model because it allows the user to adapt the model to the

security being analyzed. And as with other pricing models, it helps the user decide whether a

security is undervalued or overvalued and so he or she can profit from this information. APT

is also very useful for building portfolios because it allows managers to test whether their

portfolios are exposed to certain factors.

APT may be more customizable than CAPM, but it is also more difficult to apply because

determining which factors influence a stock or portfolio takes a considerable amount of

research. It can be virtually impossible to detect every influential factor much less determine

how sensitive the security is to a particular factor. But getting "close enough" is often good

enough; in fact studies find that four or five factors will usually explain most of a security's

return: surprises in inflation, GNP, investor confidence and shifts in the yield curve.

As its name implies, the Arbitrage Pricing Theory, or APT, describes a mechanism used by

investors to identify an asset, such as a share of common stock, which is incorrectly priced.

Investors can subsequently bring the price of the security back into alignment with its actual

value.

The APT model was first described by Steven Ross in an article entitled The Arbitrage Theory

of Capital Asset Pricing, which appeared in the Journal of Economic Theory in December

1976. The Arbitrage Pricing Theory assumes that each stock's (or asset's) return to the

investor is influenced by several independent factors.

Furthermore, Ross stated the return on a stock must follow a very simple relationship that is

described by the following formula:

Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n)

Where:

rf = the risk free interest rate, which is the interest rate the investor would expect to

receive from a risk-free investment. Typically, U.S. Treasury Bills are used for U.S.

dollar calculations, while German Government bills are used for the Euro

b = the sensitivity of the stock or security to each factor

factor = the risk premium associated with each entity

The APT model also states the risk premium of a stock depends on two factors:

The risk premiums associated with each of the factors described above

The stock's own sensitivity to each of the factors; similar to the beta concept

Risk Premium = r - rf = b(1) x (r factor(1) - rf) + b(2) x (r factor(2) - rf)... + b(n) x (r

factor(n) - rf)

If the expected risk premium on a stock were lower than the calculated risk premium using

the formula above, then investors would sell the stock. If the risk premium were higher than

the calculated value, then investors would buy the stock until both sides of the equation were

in balance. Arbitrage is the term used to describe how investors could go about getting this

formula, or equation, back into balance.

It's one thing to describe the APT theory in terms of simple formulas, but it's another matter

entirely to identify the factors used in this theory. That's because the theory itself does not tell

the investor what those factors are for a particular stock or asset, and for a very good reason.

In practice, and in theory, one stock might be more sensitive to one factor than another. For

example, the price of a share of ExxonMobil might be very sensitive to the price of crude oil,

while a share of Colgate Palmolive might be relatively insensitive to the price of oil.

In fact, the Arbitrage Pricing Theory leaves it up to the investor, or analyst, to identify each of

the factors for a particular stock. Therefore, the real challenge for the investor is to identify

three items:

The expected returns for each of these factors

The sensitivity of the stock to each of these factors

Identifying and quantifying each of these factors is no trivial matter, and is one of the reasons

the Capital Asset Pricing Model remains the dominant theory to describe the relationship

between a stock's risk and return.

Keeping in mind the number and sensitivities of a stock to each of these factors is likely to

change over time, Ross and others identified the following macro-economic factors they felt

played a significant role in explaining the return on a stock:

Inflation

GNP or Gross National Product

Investor Confidence

Shifts in the Yield Curve

With that as guidance, the rest of the work is left to the stock analyst.

As mentioned, the Arbitrage Pricing Theory and the Capital Asset Pricing Model (CAPM) are

the two most influential theories on stock and asset pricing today. The APT model is different

from the CAPM in that it is far less restrictive in its assumptions. APT allows the individual

investor more freedom to develop a model that explains the expected return for a particular

asset.

Intuitively, the APT makes a lot of sense because it removes the CAPM restrictions, and

basically states "The expected return on an asset is a function of many factors as well as the

sensitivity of the stock to these factors." As these factors move, so does the expected return

on the stock, and therefore its value to the investor.

In the CAPM theory, the expected return on a stock can be described by the movement of that

stock relative to the rest of the market. The CAPM is really just a simplified version of the

3

APT, whereby the only factor considered is the risk of a particular stock relative to the rest of

the market, as described by the stock's beta.

From a practical standpoint, CAPM remains the dominant pricing model used today. When

compared to the Arbitrage Pricing Theory, the Capital Asset Pricing Model is both elegant and

relatively simple to calculate.

1. Factor Models of Security Returns

The index model introduced earlier in Chapter 8 gives us a way of decomposing

stock variability into market or systematic risk, due largely to macroeconomic

events, versus firm-specific or idiosyncratic effects that can be diversified in large

portfolios. In the index model, the return on the market portfolio summarizes the

broad impact of macro factors. Sometimes, however, rather than using a market

proxy, it is more useful to focus directly on ultimate sources of risk. This can be

useful in risk assessment when measuring ones exposure to particular sources of

uncertainty. Factors models are tools that allow us to describe and quantify the

different factors that affect the rate of return on a security during any time period.

1. Factor Model of Security Returns

To illustrate we will start by examining a single-factor model like the one

introduced in Chapter 8. As noted there, uncertainty in asset returns has two

sources: a common or macroeconomic factor, and firm-specific events. The

common factor is constructed to have zero expected value, because we use it to

measure new information concerning the macroeconomy, which by definition,

has zero expected value.

If we call F the deviation of the common factor from its expected value, i the

sensitivity of firm i to that factor, and ei the firm-specific disturbance, the factor

model states that the actual return on firm i will equal its initially expected return

plus a (zero expected value) random amount attributable to unanticipated

economy-wide events, plus another (zero expected value) amount attributable to

firm-specific events. Formally, the single-factor model is described by Equation

10.l:

ri E(ri ) i F ei ,

10.1

where, E(ri) is the expected return on stock i. Notice that if the macro factor has a

value of 0 in any particular period (i.e., no macro surprises), the return on security

will equal its previously expected value, E(ri), plus the effect of firm-specific

events only. The non-systematic components of the return, the eis, are assumed to

be uncorrelated among themselves and uncorrelated with the factor F.

The factor model decomposition of returns into systematic and firm-specific

components is compelling, but confining systematic risk into a single factor is

5

not. Indeed, when we motivated the index model in Chapter 8, we noted that the

systematic or macro risk factor summarized by the market return arises from a

number of sources, for example, uncertainty about the business cycle, interest

rates, inflation, etc. The market return reflects macro factors as well as the

average sensitivity of firms to those factors. (When we estimate a single-index

regression, therefore, we explicitly impose an (incorrect) assumption that each stock has the

same relative sensitivity to each risk factor. If stocks actually differ in their betas relative to the

macroeconomic factors, then lumping all systematic sources of risk into one variable such as

return on the market index will ignore the nuances that better explain individual stock returns.)

How can we improve on the single-index model but still maintain the useful

dichotomy between systematic and diversifiable risk? It is easy to see that models

that allow for several systematic factors multifactor models can provide

better description of security returns. (Apart from their use in building models of equilibrium

security pricing, multifactor models are useful in risk management applications. These models give us a

simple way to measure our exposure to various macroeconomic risks, and construct portfolios to hedge

those risks.)

Lets start with a two-factor 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, which may be captured by the return on a Tbond portfolio. The return on any stock will respond both to sources of macro risk

and to its own firm-specific influences. Therefore, we can write a two-factor

model describing the excess rate of return on a stock i in some time period as

follows:

ri E ( ri ) iGDP GDP iIR IR ei ,

10.2

where IR denotes the unexpected changes in interest rates. The two macro factors

on the right-hand side of the equation comprise the systematic factors in the

economy. As in the single-factor model, both of these macro factors have zero

expectations: they represent changes in these variables that have not already been

anticipated. (The coefficient of each factor in Equation 10.2 measures the sensitivity of stock

returns to that factor; for this reason the coefficients are sometimes called factor sensitivities,

factor loading, or equivalently, factor betas.) An increase in interest rates is bad news

for most firms, so we would expect interest rate betas generally to be negative.

As before, ei reflects firm-specific influences.

Factor betas can provide a framework for a hedging strategy. The ides foe an

investor who wishes to hedge a source of risk is to establish an opposite factor

exposure to offset that particular source of risk. Often, futures contracts can be

used to hedge particular factor exposure.

The multifactor model is no more than a description of the factors that affect

security returns. There is no theory in the equation. The obvious question left

unanswered by a factor model like Equation 10.2 is where E(r) comes from, in

other words, what determines a securitys expected rate of return. This is where

we need a theoretical model of equilibrium security returns.

In previous chapters we developed one example of such a model: the security

market line (SML) of the CAPM. The CAPM asserts that securities will be

priced to give investors an expected return comprised of two components: the

risk-free rate, which is compensation for the time value of money, and a risk

premium, determined by multiplying a benchmarks risk premium (i.e. the risk

premium offered by the market portfolio) times the relative measure of risk,

beta:

E(r) r f [E(rM ) rf ]

10.3

If we denote the risk premium of the market portfolio by RPM, then, a useful way

to rewrite equation 10.3 is:

E(r) r f RPM

10.4

We pointed out in Chapter 8 that you can think of beta as measuring the

exposure of a stock or portfolio to market-wide or macroeconomic risk factors.

Therefore, one interpretation of the SML is that investors are rewarded with a

higher expected return for their exposure to macro risk, based on the sensitivity

to this risk (beta), as well as the compensation for bearing each unit of that

source of risk (i.e., the risk premium), but are not rewarded for exposure to firmspecific uncertainty (the residual term, ei in Equation 10.1).

How might this single-factor view of the world generalize once we recognize the

presence of multiple sources of systematic risk? Perhaps, not surprisingly, a

multifactor index model gives rise to a multifactor security market line (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. Such a

multifactor CAPM was first presented by Merton (1973). For example, in a twofactor economy in which the risk exposure can be measured by Equation 10.2,

we would consider that the expected rate of return on a security would be the

sum of: 1) The risk-free rate of returns, 2) The sensitivity to GDP (i.e., the GDP

beta) times the risk premium for bearing GDP risk, and 3) The sensitivity to

interest rate risk (i.e., the IR beta) times the risk premium for bearing interest

rate risk. This assertion is expressed as follows in Equation 10.5:

7

10.5

In that equation, GDP denotes the sensitivity of the security return to unexpected

changes in GDP growth, and RPGDP = [E(rGDP) - rf] is the risk premium

associated with one unit of GDP exposure, that is, the exposure corresponding

to a GDP beta of 1.0.

It is clear that Equation 10.5 is a generalization of the simple security market

line. In the single-factor SML, the benchmark risk premium is given by the risk

premium of the market portfolio, but once we generalize to multiple risk

sources, each with its own risk premium, we see that the insights are very

similar. However, one difference between a single- and multi-factor economy is

that a factor risk premium can be negative. For example, a security with a

positive interest rate beta performs better when rates increase, and thus would

hedge the value of a portfolio against interest rate risk. Investors might well

accept a lower rate of return, that is, a negative risk premium, as the cost of this

hedging attribute. In contrast, a more typical security that does worst when rates

increase (a negative-IR beta) adds to interest rate exposure, and therefore has a

higher required rate of return. Equation 10.5 shows that the contribution of

interest rate risk to required return for such a security would than be positive, the

product of a negative-factor beta times a negative-factor risk premium.

Another reason that multifactor models can improve on the descriptive power of the index

model is that betas seem to vary over the business cycle. In fact, some of the variables that are

used to predict beta are related to the business cycle (e.g., earnings growth). Therefore, it makes

sense that we can improve the single-index model by including variables that are related to the

business cycle.

We still need to specify how to estimate the risk premium for each factor.

Analogously to the simple CAPM, the risk premium associated with each factor

can be thought of as the risk premium of a portfolio that has a beta of 1.0 on that

particular factor, and a beta of zero on all other factors. In other words, it is the

risk premium one might expect to earn by taking a pure play on that factor. For

now lets just take the factor risk premiums as given and see how a multifactor

SML might be used.

10.2 ARBITRAGE PRICING THEORY

Stephen Ross developed the Arbitrage Pricing Theory (APT) in 1976. Like

CAPM, the APT predicts a security market line linking the expected returns to

risk, but the path it takes to the SML is quite different. Rosss APT relies on

three key propositions: 1) security returns can be described by a factor model, 2)

8

there are sufficient securities to diversify away the idiosyncratic rick, and 3)

well-functioning security markets do not allow for the persistence of arbitrage

opportunities. We begin with a simple version of Rosss model, which assumes

that only one systematic factor affects security returns.

1. Arbitrage, Risk Arbitrage, and Equilibrium

To understand the APT we begin with the concept of arbitrage, which is the act

of exploiting the mispricing of two or more securities to achieve risk-free

economic profits. An arbitrage opportunity arises when an investor can earn

riskless profit without making a net investment; in other words when the

investor can construct a zero investment portfolio that will yield a sure profit. To

construct a zero investment portfolio one has to be able to sell short at least one

asset and use the proceeds to purchase (go long on) one or more assets.

Borrowing may be viewed as a short position in the risk-free asset. Clearly, any

investor would like to take as large a position as possible in an arbitrage

portfolio.

An obvious case of an arbitrage opportunity arises when the Law of One Price is

violated. For example, consider a security that is priced differently in two markets

(and the price differential exceeds transaction costs). A long position in the

cheaper market financed by a short position in the more expensive one will lead

to a sure profit. The net proceeds are positive, and there is no risk because the

long and short positions offset each other. The Law of One Price is enforced by

arbitrageurs; if they observe a violation of the law, they will engage in arbitrage

activity simultaneously buying the asset where it is cheap and selling where it

is expensive. In the process, they will bid up the price where it is low and force

it down where it is high until the arbitrage opportunity is eliminated. (The idea that

market prices will move to rule out arbitrage opportunities is perhaps the most fundamental

concept in capital market theory. Violation of this restriction would indicate the grossest form

of market irrationality.)

regardless of risk aversion or wealth, will want to take an infinite position in it.

Because those large positions will force prices up or down until the opportunity

vanishes, we can derive restrictions on security prices that satisfy a "noarbitrage" condition, that is, a condition that rules out the existence of arbitrage

opportunities.

The CAPM is an example of a dominance argument, implying that all investors

hold mean-variance efficient portfolio. If a security is mispriced, then investors

will tilt their portfolios toward the underpiced and away from the overpriced

securities. Pressure on equilibrium prices results from many investors shifting

their portfolios, each by a relatively small dollar amount. The assumption that a

large number of investors are mean-variance sensitive is critical. In contrast, the

implication of a no-arbitrage condition is that a few investors who identify an

arbitrage opportunity will mobilize large dollar amounts and quickly restore the

equilibrium.

Practitioners often use the terms "arbitrage" and "arbitrageurs" more loosely

than our strict definition. "Arbitrageur" often refers to a professional searching

for mispriced securities in specific areas such as merger-target stocks, rather than

to one who seeks strict (risk-free) arbitrage opportunities. Such activity is

sometimes called risk arbitrage to distinguish it from pure arbitrage.

2. Well-Diversified Portfolios

The first to apply this concept to equilibrium security returns was Ross (1976)

who developed the Arbitrage pricing theory (APT). The APT depends on the

assumption that well-functioning capital markets preclude arbitrage

opportunities. A violation of the APTs pricing relationships will cause

extremely strong pressure to restore them even if only a limited number of

investors become aware of the disequilibrium. Rosss accomplishment is to

derive the equilibrium rates of return and risk premiums that would prevail in a

market where prices are in alignment to the extent that arbitrage opportunities

have been eliminated.

Suppose now that we construct a highly diversified portfolio with a given beta.

If we use enough securities to form the portfolio, its firm-specific or non-factor

risk can be diversified away. Only the factor (or systematic) risk remains. If we

construct an n-stock portfolio with weights wi, (wi = 1), then the rate of return

on this portfolio is as follows:

rP E(RP ) P F e P ,

10.6

expected return of the n securities,. The portfolio non-systematic component

(which is uncorrelated with risk factor, F) is eP wi ei , which similarly is a

weighted average of the ei of the n securities.

We can divide the variance of the portfolio into systematic and non-systematic

sources as wee saw in Chapter 8. The portfolio variance is:

P2 P2 F2 2 (eP ) ,

10

2

where F is the variance of the factor F, and (e ) is the non-systematic risk

of the portfolio, which is given by:

p

If the portfolio were equally weighted, that is wi = 1/n, then the non-systematic

variance would be:

2

2 (eP , wi

1

1 2 (ei ) 1 2

1

) 2 (ei )

(ei ) ,

n

n

n

n

n

where the last term is the average value across securities of non-systematic

variance. In words, the non-systematic variance of the portfolio equals the

average non-systematic variance, (e ) , divided by n. Therefore, when the

portfolio gets large in the sense that n is large, its non-systematic variance

approaches zero. This is the effect of diversification.

2

We conclude that for the equality weighted portfolio, the non-systematic variance

approaches zero as n becomes ever larger. This property is true of portfolios

other than the equally weighted ones. Any portfolio for which the weight wi

become consistently smaller as n gets larger will satisfy the condition that the

portfolio non-systematic risk will approach zero. In fact, this property motivates

us to define a well-diversified portfolio as one that is diversified over a large

enough number of securities, with each weight (wi) small enough that for

practical purposes the non-systematic variance, 2(ep), is negligible.

Because the expected (mean) value of ep for any well-diversified portfolio is zero,

and its variance is also effectively zero, we can conclude that any realized value

of ep will be virtually zero. Rewriting Equation 10.1, we conclude that for a welldiversified portfolio, for all practical purposes, the return is:

rP E(RP ) P F ,

P2 P2 F2 p P F

Large (mostly institutional) investors can hold portfolios of hundreds and even

thousands of securities; thus the concept of well-diversified portfolios clearly is

operational in contemporary financial markets. Well-diversified portfolios,

however, are not necessarily equally weighted.

3. Betas and Expected Returns

11

Because nonfactor risk can be diversified away, only factor risk should command

a risk premium in market equilibrium. Non-systematic risk across firms cancels

out in well-diversified portfolios; one would not expect investors to be rewarded

for bearing risk that can be eliminated through diversification. Instead, only

systematic risk of a portfolio of securities should be related to its expected return.

Figure 10.1 in the textbook illustrates the difference between a single security

with a beta of 1.0 and a well-diversified portfolio with the same beta. The

expected return of the portfolio is 10%; this is where the solid line crosses the

vertical axes. At this point the systematic factor is zero, implying no macro

surprises. For the portfolio (Panel A), all the returns plot exactly on SML; there is

no dispersion around the line as in Panel B (individual stock), because the effects

of the firm-specific events are eliminated by diversification. So, the well-diversify

portfolios return is determined completely by the systematic risk factor.

Now consider Figure 10.2, where the dash line plots the return of another welldiversified portfolio, portfolio B, with an expected return of 8% and beta also

equal to 1.0. Could portfolio A and B coexist with the return patterns depicted?

Clearly not: No matter what systematic factor turns out to be, the portfolio with

higher return (A) outperforms the one with lower return (B), leading to an

arbitrage opportunity.

The example in the textbook shows that if you sell short $1 million of B and buy

$1 million of A, you would have a riskless payoff of $20,000. Your profit is riskfree because the factor risk cancels out across the long and shot positions.

Moreover, the strategy requires zero net investment. You should pursue it on an

infinitely large scale until the return discrepancy between the two portfolios

disappears. Well-diversified portfolios with equal betas must have equal

expected returns in market equilibrium, or arbitrage opportunities do exist.

In fact we can go further and show that the alpha of any well-diversified portfolio (see equation

below) must be zero, even if the beta is not zero. The proof is similar to the easy zero-beta case.

If the alphas were not zero, then we could combine two of these portfolios into a zero-beta

riskless portfolio with a rate of return not equal to the risk-free rate. But this would be an

arbitrage opportunity.

R P P P RM

10.7

What about portfolios with different betas? In this case their risk premiums must

be proportional to portfolio beta. For a proof of this property see Figure 10.3 in

the textbook. We find that portfolio D has an equal beta but a greater expected

return than portfolio C. From our previous analysis we know that this constitutes

an arbitrage opportunity.

12

well-diversified portfolios must lie on the straight line from the risk-free asset in

Figure 10.3. Note that risk premiums are indeed proportional to portfolio betas.

The risk premium is depicted by the vertical arrow, which measures the distance

between the risk-free rate and the expected return on the portfolio. The risk

premium is zero for = 0 and rises in direct proportion to beta.

To prove that, suppose that portfolio V has a beta of V and an alpha of V.

Similarly, suppose that portfolio U has a beta of U and an alpha of U. Taking

advantage of any arbitrage opportunity involves buying and selling assets in

proportions that create a risk-free profit on a costless position. To eliminate the

risk we buy portfolio V and sell portfolio U in propositions chosen so that the

combination (portfolio Z) will have a beta of zero. The portfolio weights that

satisfy this condition are:

wV

- U

V

wU

,

and

V U

V U

Note that the two weights add up to 1.0 and that beta of the combination

portfolio is in fact zero:

Z wV V wU U

- U

V

V

U 0

V U

V U

because its beta is zero. But the excess return of the portfolio is not zero unless

V and U equal zero.

RZ

- U

V

V

U 0

V U

V U

Therefore, unless the two alphas equal zero, the zero-beta portfolio has a certain

rate of return that differs from risk-free rate (its excess return is different from

zero.) To rule out this arbitrage opportunity it must earn only the risk-free rate.

Therefore:

E(rZ ) wV E(rV ) wU E(rU ) r f

Rearranging the above equation, we can conclude that risk premiums are indeed

proportional to portfolio betas:

13

E(rV ) rf

V

E(rU ) rf

U

We conclude that the only value for alpha that rules out arbitrage opportunities is

zero. Therefore, we rewrite Equation 10.7 setting alpha equal to zero:

RP P RM , or rP rf P [rM rf ]

measure the systematic risk factor as the unexpected return on the market

portfolio. Because the market portfolio must be on the SML and the beta of the

market portfolio is 1.0, we can rearrange the equation above as:

E(rP ) r f P [E(rM ) r f ]

10.8

Hence, this equation is identical to SML relation of the CAPM (see Figure 10.4

in the textbook, where the intercept is rf, and the slope is E(rM) rf). We have

used the no-arbitrage condition to obtain an expected return-beta relationship

identical to that of the CAPM, without the restrictive assumptions of the CAPM.

Our demonstration suggest that despite its restrictive assumptions, the main

conclusion of the CAPM, namely, the (SML) expected return-beta relationship

should be at least approximately valid.

It is worth noting 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 lying on the SML in Figure 10.4 may serve as the

benchmark portfolio. For example, one might define the benchmark portfolio as

the well-diversified portfolio most highly correlated with whatever systematic

factor is thought to affect stock returns. Accordingly, the APT has more

flexibility than does the CAPM because problems associated with an

unobservable market portfolio are not a concern.

In addition, the APT provides further justification for use of the index model in the practical

implementation of the SML relationship. Even if the index portfolio is not a precise proxy for

the true market portfolio, which is a cause of considerable concern in 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.

We have demonstrated that if arbitrage opportunities are to be ruled out, each

well-diversified portfolios expected (excess) return must be proportional to its

beta. The question is whether this relationship tells us anything about the

14

expected returns on the component stock. The answer is that if this relationship

is to be satisfied by all well-diversified portfolios it must be satisfied by almost

all individual assets although the proof of this proposition is somewhat difficult.

We said almost because, according to the APT, there is no guarantee that all

individual assets will lie on SML. If for example, only one security violates the

SML, then the effect of this violation on a well-diversified portfolio will be too

small to be of importance for any particular purpose, and meaningful arbitrage

opportunities will not arise. But if many securities violate the expected returnbeta relationship, the relationship will no longer hold for well-diversified

portfolios comprising these securities, and arbitrage opportunities will be

available. Consequently, we conclude that imposing the no-arbitrage condition

on a single-factor security market implies maintenance of the expected returnbeta relationship for all well-diversified portfolios and for all but possibly a

small number of individual securities.

1. The APT and the CAPM

The APT serves many of the same functions as the CAPM. It gives us a

benchmark for rates of return that can be used in capital budgeting, security

valuation, or investment performance evaluation. Moreover, the APT highlights

the critical distinction between the non-diversifiable risk (factor risk) that

requires a reward in the form of risk premium and diversifiable risk that does

not.

The APT is an extremely appealing model. It depends on the assumption that a

rational equilibrium in capital markets precludes arbitrage opportunities. A

violation of the APT pricing relationships will cause extremely strong pressure

to restore them even if only a limited number of investors become aware of

disequilibrium. Furthermore, the APT yields an expected return-beta relationship

using a well-diversified portfolio that practically can be constructed from a large

number of securities.

In contrast, the CAPM is derived assuming an inherently unobservable "market"

portfolio. The CAPM argument rests on mean-variance efficiency, that is, if any

security violates the expected return-beta relationship, then, many investors

(each relatively small) will tilt their portfolios so that their combined overall

pressure on prices will restore an equilibrium that satisfied the relationship.

In spite of these appealing advantages, the APT does not fully dominate the

CAPM. The bottom line is that neither of these theories dominates the other. The

APT is more general in that it gets us to the expected return-beta relationship

without requiring many of the unrealistic assumptions of the CAPM, particularly

15

the reliance on the market portfolio. The latter improves the prospects for testing

the APT. But the CAPM is more general in that it applies to all assets without

reservation. The good news is that both theories agree on the expected return-beta

relationship.

A more productive comparison is between the APT and the index model. The

implication of the index model is that the market index portfolio is efficient and

that the expected return-beta relationship holds for all assets. The assumption

that the probability distribution of security returns is stationary (so that sample

period returns can provide valid estimates of expected returns and variances) and

the observability of the index make it possible to test the efficiency of the index

portfolio and the expected return-beta relationship. In contrast, the APT uses a

single-factor security market assumption and arbitrage arguments to obtain the

expected return-beta relationship for well-diversified portfolios. Because it

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 returnbeta relationship for any particular asset. For this, we need the CAPM

assumptions and its dominance arguments.

10.4 A MULTIFACTOR APT

We have assumed so far that only one systematic factor affects stock returns. This

simplifying assumption is in fact too simplistic. We have noted that it is easy to

think of several factors driven by the business cycle that might affect stock

returns: interest rate fluctuations, inflation rates, oil prices, and so. Presumably,

exposure to any of those factors will affect a stocks risk and hence, its expected

rate of return. We can derive a multifactor version of the APT to accommodate

these multiple sources of risk.

Suppose that we generalize the single-factor model expressed in Equation 10.1 to

a two-factor model:

ri E(ri ) i1 F1 i2 F2 ei

10.8a

In example 10.2, factor 1 was the departure of GDP growth from expectations,

and factor 2 was the unanticipated changes in interest rates. Each factor has a zero

expected value because each measures the surprise in the systematic variable

rather than the level of the variable. Similarly, the firm-specific component of

unexpected return, ei, also has zero expected value. Expending such a two-factor

model to any number of factors is straightforward.

16

introduce the concept of a factor portfolio, which is a well-diversified portfolio

constructed to have a beta of 1.0 on one of the factors and a beta of zero on any

other factor. We can think of a factor portfolio as a tracking portfolio. That is, the

returns on such a portfolio track the evolution of particular sources of

macroeconomic risk, but are uncorrelated with other sources of risk. It is possible

to form such factor portfolio 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.

To generalize the arguments in Example 10.5 in the textbook for a two-factor

model, note that the factor exposures of any portfolio, P, are given by its betas,

P1 and P2. A competing portfolio, Q, can be formed by investing in factor

portfolios with the following weights: P1 in the first factor portfolio; P2 in the

second factor portfolio, and (1 - P1 - P2) in T-bills. By construction, portfolio Q

will have betas equal to those of portfolio P, and expected return of:

E(rQ ) P1 E(r1 ) P2 E(r2 ) (1 P1 P2 )rf

r f P1 [E(r1 ) r f ] P2 [E(r2 ) r f ]

10.9

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

Because portfolio Q has precisely the same exposures as portfolio A to the two

sources of risk, their expected returns also ought to be equal. So, portfolio A also

ought to have an expected return of 13%. If it does not, then there will be an

arbitrage opportunity (see Example 10.6 in the textbook.)

We conclude that any well-diversified portfolio with betas P1 and P2 must have

the return given in Equation 10.9 if arbitrage opportunities are to be precluded. If

you compare Equations 10.3 and 10.9 you will see that the above two-factor

equation is simply a generalization of the one-factor SML. So, we conclude that

the multifactor generalization of the security market line of the APT and the

CAPM are effectively equivalent.

The generalized APT must be qualified with respect to individual assets just as in

the one-factor APT. Equation 10.9 cannot be satisfied by every well-diversified

portfolio unless it is satisfied by virtually every security taken individually.

Equation 10.9 thus represents the multifactor SML for an economy with multiple

sources of risk. A multifactor CAPM would, at the cost of additional

assumptions, apply to any and all individual securities. As we have seen, the

17

identical to that of the multifactor APT. (We pointed out earlier that one application of

the CAPM is to provide fair rates of return for regulated utilities. The multifactor APT can

be used to the same ends see nearby box in the textbook on p.362.)

One shortcoming of the multifactor APT is that it gives no guidance concerning

the determination of relevant risk factors or their risk premiums. In contrast, the

CAPM implies that the risk premium on the market is determined by the market's

variance and the average degree of risk aversion across investors. Two principles

guide us when we specify a reasonable list of factors. First, we want to restrict

ourselves to a limited number of systematic factors with considerable ability to

explain security returns. Second, we wish to choose factors that seem likely to be

important risk factors, that is, factors that concern investors sufficiently so that

they will demand meaningful risk premiums to bear exposure to those sources of

risk.

As we have seen, the CAPM also has a multifactor generalization, sometimes called the

intertemporal CAPM. This model provides some guidance concerning the risk premiums on

the factor portfolios. Moreover, recent theoretical research has demonstrated that one may

estimate an expected return-beta relationship even if the true factors or factor portfolios cannot

be identified.

The multifactor CAPM and APT are elegant theories of how exposure to

systematic risk factors should influence expected returns, but they provide little

guidance concerning which factors (sources of risk) ought to result in risk

premiums. A full-blown test of the multifactor equilibrium model, with prespecified factors and hedge portfolios, is as yet unavailable. A test of this

hypothesis would require three stages:

1. Specification of risk factors

2. Identification of portfolios that hedge these fundamental risk factors

3. Test of the explanatory factors power and risk premiums of the hedge

portfolios

1. The Chen, Roll and Ross Five-Factor Model

A step in this direction was made by Chen, Roll and Ross (1986) who chose the

following set of factors based on the ability of these factors to pain a broad

picture of the macro-economy. Their set is obviously but one of many possible

sets that might be considered:

1. % change in industrial production (IP),

2. % change in expected inflation (EI),

18

4. Excess return of long-term corporate bonds over long-term government

bonds (CG), and

5. Excess return of long-term government bonds over T-bills (GB).

With the identification of these potential economic factors, Chen, Roll and Ross

skipped the procedure of identifying factor portfolios (the portfolios that have

the highest correlation with the factors). Instead, by using the factors

themselves, they implicitly assumed that factor portfolios exist that can proxy

for the factors. They use these factors in a test similar to that of Fama and

MacBeth.

A critical part of the methodology is the grouping of stocks into portfolios.

Recall that in the single-factor tests, portfolios were constructed to span a wide

range of betas to enhance the power of the test. In a multifactor framework the

efficient criterion for grouping is less obvious. Chen, Roll and Ross chose to

group the sample stocks into 20 portfolios by size (market value of outstanding

equity), a variable that is known to be associated with stock returns.

They first used five years of monthly data to estimate the factor betas of the 20

portfolios in a first-pass regression. This is accomplished by estimating the

following regressions for each portfolio:

rP M rM IP IP EI EI UI UI CG CG GB GB eP

10.10a

where M stands for the stock market index. Chen, Roll and Ross used as the

market index both the value-weighted NYSE index (VWNY) and the equally

weighted NYSE index (EWNY).

Using the 20 sets of first-pass estimates of factor betas as independent variables,

they now estimated the second-pass regression (with 20 observations, one for

each portfolio) as follows:

rP 0 M M IP IP EI EI UI UI CG CG GB GB eP ,

10.10b

Chen, Roll and Ross (1986) ran this second-pass regression for every month of

their sample period, re-estimating the first-pass factor betas once every 12

months. The estimated risk premiums (the values for the parameters, s) were

averaged over all the second-pass regressions. The results of the regressions

show that the two market indexes EWNY and VWNY are not significant (their tstatistics of 1.218 and -0.633 are less than 2). Note also that the VWNY factor

19

has the wrong sign in that it seems to imply a negative market-risk premium.

Industrial production (IP), the risk premium on corporate bonds (CG), and

unanticipated inflation (UI) are the factors that appear to have significant

explanatory power (see also Chapter 13, Table 13.4 on p.447).

2. The Fama-French Three-Factor Model

An alternative approach to specifying macroeconomic factors as candidates for

relevant sources of systematic risk uses firm characteristics that seem, on

empirical ground, 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 premium. One example of this approach is the Fama and

French (1996) free-factor model, which has come to dominate empirical research

and industry applications.

Fama and French added firm size and book-to-market ratio to the market index to

explain average returns. These additional factors are motivated by observations

that average returns on stocks of small firms and on stocks of firms with a high

ratio of book value to market value of equity have historically been higher than

predicted by the security market line of the CAPM. This observation suggests that

size or book-to-market ratio may be proxies for exposures to sources of

systematic risk not captured by the CAPM beta, and thus result in risk premium.

Fama and French (1996) proposed the following multifactor model:

Rit i iM RMt iSMB SMBt iHML HMLt eit

10.11

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-tomarket ratio in excess of the return on a portfolio of stocks with a low bookto-market ratio

Taking the difference in returns between two portfolios has an economic interpretation. The SMB

return, for example, equals the return from a long position in small stocks financed with a short

position in the large stocks. Note that this is a portfolio that entails no net investment. As a result, there

is no compensation for time value of money, only for risk, and the total return therefore may be

interpreted as a risk premium. Note that in this model the market index does play a role

These two firm-characteristic variables 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 CAPM. Fama and

20

French justify this model on empirical grounds: while SMB and HML are not

themselves obvious candidates for relevant risk factors, the argument are that these

variables may proxy for yet-unknown more-fundamental variables. For example,

Fama and French point out that 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 in

changes in business conditions, Thus, these variables may capture sensitivity to risk

factors in the macroeconomics.

The problem with empirical approaches such as the Fama and French model, which

use proxies for extra-market 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 and rescan the database of security

returns in search for explanatory factors (an activity often called data-snooping), they

may eventually uncover past patterns that are due purely to chance. Black observes

that return premiums to factors such as firm size have proven to be inconsistent since

first discovered. 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.

10.6 THE MULTIFACTOR CAPM AND THE APT (optional) p.364

21

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