Arbitrage Pricing Theory

An alternative model of equilibrium security pricing (Ross, S., 1976,

Journal of Economic Theory Vol. 13: 341-360).
Hypothesis: When the assets market is in equilibrium, expected return
on an asset (or portfolio) is a linear function of its risk with respect to a
set of factors.
Factors represent broad economic forces that affect all securities
prices (thus returns, not firm-specific events or characteristics.
More general than CAPM, with less restrictive assumptions, but has
limitations and is not the final word in asset pricing.
Assets prices fluctuate because of both idiosyncratic or firm-specific or
nonsystematic risk and systematic risks.
But APT predicts that a well-functioning capital market rewards
investors ONLY for bearing systematic risks since idiosyncratic
risk can be eliminated by holding many securities in the portfolio.
APT is not critically dependent on an underlying market portfolio as in
CAPM. Instead, APT recognizes that several types of risks may
systematically affect the returns on ALL securities.
APT is based on the LAW OF ONE PRICE: two identical assets cannot
sell at different prices.
APT assumes that actual returns and expected returns are both
linearly related to a set of factors.
Market participants develop expectations about the sensitivities of
each asset return to these factors.
Buy and sell securities so that securities affected equally by
the same factors will have equal expected returns.
This buying and selling is the ARBITRAGE PROCESS
which determines the prices of securities.
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APT predicts that in equilibrium, the market prices of assets will

adjust to eliminate any ARBITRAGE OPPORTUNITIES among
well-diversified portfolios.
Arbitrage opportunities occurs when a ZERO
INVESTMENT PORTFOLIO that will yield a RISKLESS
PROFIT can be constructed.
If arbitrage opportunities arise, APT argues that a
relatively few investors can act (buy or sell securities to take
advantage of the arbitrage profit) to restore equilibrium.
Assumptions of APT
Like CAPM, APT assumes:
1. investors have homogenous beliefs
2. investors are risk-averse expected utility maximizers
3. asset markets are perfectly competitive: there are an unlimited
number of assets, so investors can form well-divesified portfolios
that eliminate firm-specific or asset-specific risk
4. there are no restrictions on short selling of any of the assets
5. realized returns are generated by a factor model
Unlike CAPM, APT does not assume
1.
2.
3.
4.

a single period investment horizon

absence of taxes
borrowing and lending at the risk-free rate
investors selection of portfolios on the basis of expected return
and variances (Markowitz Model)

Deriving the APT

APT assumes that the actual return on any asset i and for any time t
follows a K-factor Model:

rit = ai + bi1 f1t + bi2 f2t +! + biK f Kt + ! it

Notes:
ai = i = expected return on asset i, a constant overtime

Var it = 2i for all t

E it = 0 for all t

E f kt = 0 for all k and for all t

factor sensitivities biks can be > 0 or < 0
For portfolios, rPt = aP + bP1 f1t + bP 2 f2t +! + bPK f Kt + ! Pt
where aP and the bPks are as defined in the Multi Factor Model
- simple weighted averages of individual assets ai s and biks:
N

P = X i i
i =1

i =1

bPk = X i bik

for k = 1,L , K

Pt = X i it
i =1

APT assumes

E it jt = 0

Cov it , jt = 0

Corr it , jt = 0

for all i and j (i j) and for all t

nonsystematic risk of any portfolio P of N securities can be

N

written as 2 = X i2 2
P
i
i =1

2
2
portfolio variance (total risk) is ! P2 = bP1
! 2f +!+ bPK
! 2f + ! "2
1

where

bPk = X i bik
i =1

2f k Var ( f k ) and 2P = X i2 2i
j =1

In this formulation, it is assumed that Cov f st , f kt = 0 for all

factors s and k (s k) and for all t, although this is not a necessary

assumption of APT.
This is because even if there are nonzero covariance between
factors in P2 , such nonzero factor covariances will eventually
drop out for zero-beta (arbitrage) portfolios.
APT assumes

E it f kt = 0

Cov it , f kt = 0

Corr it , f kt = 0

for all i and for all k.

The above model is known as a factor model of returns, but it does not
say anything about equilibrium.
Need to transform above equation into an equilibrium model. How will
the APT equilibrium expected return - risk relationship look like?
Consider asset is actual return

rit = ai + bi1 f1t + bi2 f2t +! + biK f Kt + ! it

(1)

Taking the expectation of (1), we get

E rit = ai

(2)

since APT assumes E it = 0 for all t and E f kt = 0 for all k and for

all t.
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Subsitute (2) in (1)

rit = E !" rit #$ + bi1 f1t + bi2 f2t +! + biK f Kt + % it

(3)

Recall that APT assumes that Corr it , jt = 0 Corr it , f kt = 0 .

Now, an arbitrage or zero-beta portfolio must satisfy two conditions [(4)

and (5)]
Zero risk:

bPk = X i bik = 0

(4)

i =1

(zero-beta)
for all k = 1, . . . , K.
Zero investment:

Xi = 0

i =1

(5)

(self-financing portfolio)
Since in the arbitrage portfolio, some securities will be sold short
( X i < 0 for some i) and proceeds used to buy other securities ( X i > 0
for other i)
Arbitrage condition:
If investors have zero investment in the zero beta portfolio and
earns a positive (nonzero) expected return, then a risk-free profit
can be earned by arbitrage.

This arbitrage condition implies that

N

rPt = ! X i rit
i=1
N

rPt = ! X i E "# rit $% + bi1 f1t +!+ biK f Kt + & it

i=1
N

' N
*
X i E "# rit $% + ) X ibi1 , f1t
( i=1
+
i=1

rPt = !

' N
*
+!+ ) X ibiK , f Kt
( i=1
+

using ( 3 )
N

( 6)

+ ! X i & it
i=1

Model (6) is for actual portfolio return and does not yet say anything
when the capital market is in equilibrium.
APT has predictions on expected return on well-diversified portfolios
and on expected return on individual assets (clearly not welldiversified).
Create the arbitrage portfolio using (4) and (5) in (6) and the
assumption that for a large well-diversified portfolio, the nonsystematic
N

risk diversifies to zero ( P = X i2 2i 0 , since as N then Xi and

2

j =1

X i2

0 ), then (6) can be written as

N

rPt = X i E rit = E rPt

i =1

( 7)

where the second equality holds by definition of portfolio expected

return.
Since the arbitrage portfolio has an actual return rPt equal to expected
return E rPt , then there is zero variability in its return and is
therefore riskless!
That is,

E rPt =

X i E rit > 0

i =1

( 8)
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Now, given the (orthogonality) conditions

E it f kt = 0 ,
E rPt =

X i bik = 0 ,
i =1

Xi = 0,

i =1

X i E rit > 0

i =1

then, it can be shown that the expected return on any well-diversified

portfolio may be written as a linear combination of the factor betas, i.e.,

E !" rPt #$ = %0 +%1bP1 +!+ % K bPK

where

E rPt aP = expected return on portfolio P

0 = expected return on a zero-beta portfolio (risky portfolio with
zero sensitivity to all factors) or the risk-free rate, rf, if a riskfree asset exists
k = the risk premium for factor k = fk 0, for k = 1, . . . , K are
the same for all portfolios
bPk = the sensitivity of the return on a well-diversified portfolio P
to factor k
For individual securities which are clearly not well-diversified, APT
prediction on its expected return is an approximation

E !" rit #$ % &0 +&1bi1 +!+ & K biK

where

ai = i = expected return on individual security i or a

portfolio i with idiosyncratic risk
bik = the sensitivity of the individual asset or portfolio i with
idiosyncratic risk to factor k

Only an approximation since the general relationship may not hold

exactly (i.e., there will be deviations) due to the presence of firm-specific
risk.
Interpretation of the risk premia ks:
Assume a two-factor Exact APT

E rPt = 0 +1bP1 + 2bP 2

Consider a well-diversified zero-beta portfolio, i.e., bP1 = bP 2 = 0 which
has expected return E rZ .

Then,

E rPt = 0 +1 ( 0) + 2 ( 0) = 0

0 = E rZ .

If riskless borrowing and lending exist, then E rZ = r f

0 = r f .

Next, consider a well-diversified portfolio with bP1 = 1 and bP 2 = 0

with expected return E !# rP $& .
" 1%
Since this portfolio mimics the unexpected movements in factor 1 (a.k.a.
factor 1 portfolio), then

E rP = f1 = 0 +1 (1) + 2 ( 0 ) = 0 +1

1 = f1 0

1 = f1 E rZ .

If riskless borrowing and lending exist then

1 = f1 r f

Similarly, 2 = f 2 E rZ or 2 = f 2 r f if riskless borrowing and

lending exist.

Thus, k represents the expected return on a portfolio whose beta with

respect to factor k is 1 and 0 for all other factors.
Hence, at equilibrium, the two-factor APT predicts that for welldiversified portfolios,

E rPt = E rZ + f1 E rZ bP1 + f 2 E rZ bP 2

or

E !" rPt #$ = r f + !" f1 % r f #$ bP1 +!+ !" f K % r f #$ bPK if riskless borrowing and
lending exist.
To generalize for K factors, the K-factor APT predicts that for welldiversified portfolios

E !" rPt #$ = E !" rZ #$ + !" f1 % E !" rZ #$ #$ bP1 +!+ !" f K % E !" rZ #$ #$ bPK
or

E !" rPt #$ = r f + !" f1 % r f #$ bP1 +!+ !" f K % r f #$ bPK if riskless borrowing and
lending exist.
Summary: APT can be summarized in two equations
Exact APT: for well-diversified portfolios
(1) rPt = aP + bP1 f1t + bP 2 f2t +! + bPK f Kt + ! Pt

and

(2) E !" rPt #$ = %0 + %1bP1 + %2bP 2 +! + % K bPK , where E rPt = aP

Approximate APT: for individual securities and portfolios with

firm-specific risk
(1) rit = ai + bi1 f1t + bi2 f2t +! + biK f Kt + ! it

and

(2) E !" rit #$ % &0 + &1bi1 + &2bi2 +! + & K biK , where E rit = ai
Empirical Implementation of APT
* Alternative 1: Two-Step Procedure
Step 1. Estimate Equation (1)
First-pass regression: Time series regression of rit on a constant and on
a set of factors f kt , k = 1, . . . , K, using observations t = 1, . . . , T will
yield estimates of ai ,bi1 ,bi2 ,!,biK .
This can be repeated for i = 1, . . . , m securities so that we have m values
for each of the ai s and bik s.
Step 2. Estimate Equation (2)
Second-pass regression: Cross-section regression of the estimate of ai
on a constant and the estimates of bi1 ,!,biK from the first-pass
regression in Step 1, for i = 1, . . . , m.
This will yield estimates of the ks, k = 1, . . . , K, which are the same for
all securities.
The risk-free rate or expected return on the zero-beta (arbitrage)
portfolio, 0, is constant across securities and hence is the estimate of
the constant in this second-pass regression.

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 Alternative 2: Factor Analysis (FA)

- superior to the two-step procedure
- FA estimates the two equations implied by APT simultaneously
- However, there are some problems in interpreting the results
from FA

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Graph for page 6 of APT Lecture Notes (One-Factor APT)

i
E
F
C
B

E rZ

bi 1

12

Graph for page 8 of APT Lecture Notes (One-Factor APT)

i
F
E
C
B

E rZ

bi 1

13

Graph for page 10 of APT Lecture Notes (Two-Factor APT)

bi 2

bi 1

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Example 3:
Assume a two-factor APT. Further assume that the three portfolios
below are well-diversified such that all firm-unique risk is zero (i.e.,
2 = 0 for all j). The expected return and the beta with respect to the
two factors for the three portfolios are given as follows
j

Portfolio
B
C
D

E rP
16%
14%
11%

bP1

bP2

1
0.6
0.5

0.7
1.0
0.4

Suppose all three portfolios are correctly priced according to APT.

1. What is the risk-free rate? What are the factor risk premia?
2. Suppose there is a fourth portfolio U with expected return of
15.66%, factor 1 beta of 0.7 and factor 2 beta of 0.7. Is portfolio U
correctly priced according to APT? If not, is it overpriced or
underpriced?
3. If an arbitrage opportunity exists, design an arbitrage portfolio
using the four portfolios and show it involves zero investment,
zero risk and positive profit.

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