Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

CHAPTER10:ARBITRAGEPRICINGTHEORY
ANDMULTIFACTORMODELSOFRISKANDRETURN
PROBLEMSETS
1.

Therevisedestimateoftheexpectedrateofreturnonthestockwouldbetheold
estimateplusthesumoftheproductsoftheunexpectedchangeineachfactortimesthe
respectivesensitivitycoefficient:
revisedestimate=12%+[(12%)+(0.53%)]=15.5%

2.

TheAPTfactorsmustcorrelatewithmajorsourcesofuncertainty,i.e.,sourcesof
uncertaintythatareofconcerntomanyinvestors.Researchersshouldinvestigatefactors
thatcorrelatewithuncertaintyinconsumptionandinvestmentopportunities.GDP,the
inflationrate,andinterestratesareamongthefactorsthatcanbeexpectedtodetermine
riskpremiums.Inparticular,industrialproduction(IP)isagoodindicatorofchangesin
thebusinesscycle.Thus,IPisacandidateforafactorthatishighlycorrelatedwith
uncertaintiesthathavetodowithinvestmentandconsumptionopportunitiesinthe
economy.

3.

Anypatternofreturnscanbeexplainedifwearefreetochooseanindefinitelylarge
numberofexplanatoryfactors.Ifatheoryofassetpricingistohavevalue,itmust
explainreturnsusingareasonablylimitednumberofexplanatoryvariables(i.e.,
systematicfactors).

4.

Equation10.9applieshere:
E(rp)=rf+P1[E(r1)rf]+P2[E(r2)rf]
Weneedtofindtheriskpremium(RP)foreachofthetwofactors:
RP1=[E(r1)rf]andRP2=[E(r2)rf]
Inordertodoso,wesolvethefollowingsystemoftwoequationswithtwounknowns:
31=6+(1.5RP1)+(2.0RP2)
27=6+(2.2RP1)+[(0.2)RP2]
Thesolutiontothissetofequationsis:
RP1=10%andRP2=5%
Thus,theexpectedreturnbetarelationshipis:
E(rP)=6%+(P110%)+(P25%)

10-1

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

5.

TheexpectedreturnforPortfolioFequalstheriskfreeratesinceitsbetaequals0.
ForPortfolioA,theratioofriskpremiumtobetais:(126)/1.2=5
ForPortfolioE,theratioislowerat:(86)/0.6=3.33
Thisimpliesthatanarbitrageopportunityexists.Forinstance,youcancreateaPortfolio
Gwithbetaequalto0.6(thesameasEs)bycombiningPortfolioAandPortfolioFin
equalweights.TheexpectedreturnandbetaforPortfolioGarethen:
E(rG)=(0.512%)+(0.56%)=9%
G=(0.51.2)+(0.50)=0.6
ComparingPortfolioGtoPortfolioE,Ghasthesamebetaandhigherreturn.Therefore,
anarbitrageopportunityexistsbybuyingPortfolioGandsellinganequalamountof
PortfolioE.Theprofitforthisarbitragewillbe:
rGrE=[9%+(0.6F)][8%+(0.6F)]=1%
Thatis,1%ofthefunds(longorshort)ineachportfolio.

6.

Substitutingtheportfolioreturnsandbetasintheexpectedreturnbetarelationship,we
obtaintwoequationswithtwounknowns,theriskfreerate(rf)andthefactorrisk
premium(RP):
12=rf+(1.2RP)
9=rf+(0.8RP)
Solvingtheseequations,weobtain:
rf=3%andRP=7.5%

7.

a.

Shortinganequallyweightedportfolioofthetennegativealphastocksand
investingtheproceedsinanequallyweightedportfolioofthetenpositivealpha
stockseliminatesthemarketexposureandcreatesazeroinvestmentportfolio.
DenotingthesystematicmarketfactorasRM,theexpecteddollarreturnis(noting
thattheexpectationofnonsystematicrisk,e,iszero):
$1,000,000[0.02+(1.0RM)]$1,000,000[(0.02)+(1.0RM)]
=$1,000,0000.04=$40,000
Thesensitivityofthepayoffofthisportfoliotothemarketfactoriszerobecause
theexposuresofthepositivealphaandnegativealphastockscancelout.(Notice
thatthetermsinvolvingRMsumtozero.)Thus,thesystematiccomponentoftotal
riskisalsozero.Thevarianceoftheanalystsprofitisnotzero,however,sincethis
portfolioisnotwelldiversified.

10-2

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Forn=20stocks(i.e.,long10stocksandshort10stocks)theinvestorwillhavea
$100,000position(eitherlongorshort)ineachstock.Netmarketexposureiszero,
butfirmspecificriskhasnotbeenfullydiversified.Thevarianceofdollarreturns
fromthepositionsinthe20stocksis:
20[(100,0000.30)2]=18,000,000,000
Thestandarddeviationofdollarreturnsis$134,164.
b.

Ifn=50stocks(25stockslongand25stocksshort),theinvestorwillhavea
$40,000positionineachstock,andthevarianceofdollarreturnsis:
50[(40,0000.30)2]=7,200,000,000
Thestandarddeviationofdollarreturnsis$84,853.
Similarly,ifn=100stocks(50stockslongand50stocksshort),theinvestorwill
havea$20,000positionineachstock,andthevarianceofdollarreturnsis:
100[(20,0000.30)2]=3,600,000,000
Thestandarddeviationofdollarreturnsis$60,000.
Noticethat,whenthenumberofstocksincreasesbyafactorof5(i.e.,from20to
100),standarddeviationdecreasesbyafactorof 5 =2.23607(from$134,164to
$60,000).

8.

a.

2 2 2M 2 (e)

2A (0.8 2 20 2 ) 25 2 881
2B (1.0 2 20 2 ) 10 2 500
C2 (1.2 2 20 2 ) 20 2 976

b.

Ifthereareaninfinitenumberofassetswithidenticalcharacteristics,thenawell
diversifiedportfolioofeachtypewillhaveonlysystematicrisksincethenon
systematicriskwillapproachzerowithlargen.Themeanwillequalthatofthe
individual(identical)stocks.

c.

Thereisnoarbitrageopportunitybecausethewelldiversifiedportfoliosallploton
thesecuritymarketline(SML).Becausetheyarefairlypriced,thereisno
arbitrage.

10-3

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

9.

10.

a.

Alongpositioninaportfolio(P)comprisedofPortfoliosAandBwillofferan
expectedreturnbetatradeofflyingonastraightlinebetweenpointsAandB.
Therefore,wecanchooseweightssuchthatP=Cbutwithexpectedreturn
higherthanthatofPortfolioC.Hence,combiningPwithashortpositioninCwill
createanarbitrageportfoliowithzeroinvestment,zerobeta,andpositiverateof
return.

b.

Theargumentinpart(a)leadstothepropositionthatthecoefficientof2mustbe
zeroinordertoprecludearbitrageopportunities.

a.

E(r)=6+(1.26)+(0.58)+(0.33)=18.1%

b.Surprisesinthemacroeconomicfactorswillresultinsurprisesinthereturnofthe
stock:
Unexpectedreturnfrommacrofactors=
[1.2(45)]+[0.5(63)]+[0.3(02)]=0.3%
E(r)=18.1%0.3%=17.8%
11.

TheAPTrequired(i.e.,equilibrium)rateofreturnonthestockbasedonrfandthefactor
betasis:
requiredE(r)=6+(16)+(0.52)+(0.754)=16%
Accordingtotheequationforthereturnonthestock,theactuallyexpectedreturnonthe
stockis15%(becausetheexpectedsurprisesonallfactorsarezerobydefinition).
Becausetheactuallyexpectedreturnbasedonriskislessthantheequilibriumreturn,we
concludethatthestockisoverpriced.

12.

The first two factors seem promising with respect to the likely impact on the firms cost of
capital. Both are macro factors that would elicit hedging demands across broad sectors of
investors. The third factor, while important to Pork Products, is a poor choice for a
multifactor SML because the price of hogs is of minor importance to most investors and is
therefore highly unlikely to be a priced risk factor. Better choices would focus on variables
that investors in aggregate might find more important to their welfare. Examples include:
inflation uncertainty, short-term interest-rate risk, energy price risk, or exchange rate risk.
The important point here is that, in specifying a multifactor SML, we not confuse risk
factors that are important to a particular investor with factors that are important to
investors in general; only the latter are likely to command a risk premium in the capital
markets.

10-4

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

13.

Themaximumresidualvarianceistiedtothenumberofsecurities(n)intheportfolio
because,asweincreasethenumberofsecurities,wearemorelikelytoencounter
securitieswithlargerresidualvariances.Thestartingpointistodeterminethepractical
limitontheportfolioresidualstandarddeviation,(eP),thatstillqualifiesasawell
diversifiedportfolio.Areasonableapproachistocompare2(eP)tothemarket
variance,orequivalently,tocompare(eP)tothemarketstandarddeviation.Suppose
wedonotallow(eP)toexceedpM,wherepisasmalldecimalfraction,forexample,
0.05;then,thesmallerthevaluewechooseforp,themorestringentourcriterionfor
defininghowdiversifiedawelldiversifiedportfoliomustbe.
Nowconstructaportfolioofnsecuritieswithweightsw1,w2,,wn,sothatwi=1.The
portfolioresidualvarianceis:2(eP)=w122(ei)
Tomeetourpracticaldefinitionofsufficientlydiversified,werequirethisresidual
variancetobelessthan(pM)2.Asureandsimplewaytoproceedistoassumethe
worst,thatis,assumethattheresidualvarianceofeachsecurityisthehighestpossible
valueallowedundertheassumptionsoftheproblem:2(ei)=n2M
Inthatcase:2(eP)=wi2nM2
Nowapplytheconstraint:wi2nM2(pM)2
Thisrequiresthat:nwi2p2
Or,equivalently,that:wi2p2/n
Arelativelyeasywaytogenerateasetofwelldiversifiedportfoliosistouseportfolio
weightsthatfollowageometricprogression,sincethecomputationsthenbecomerelatively
straightforward.Choosew1andacommonfactorqforthegeometricprogressionsuchthat
q<1.Therefore,theweightoneachstockisafractionqoftheweightontheprevious
stockintheseries.Thenthesumofntermsis:
wi=w1(1qn)/(1q)=1
or:

w1=(1q)/(1qn)

Thesumofthensquaredweightsissimilarlyobtainedfromw12andacommon
geometricprogressionfactorofq2.Therefore:
wi2=w12(1q2n)/(1q2)
Substitutingforw1fromabove,weobtain:
wi2=[(1q)2/(1qn)2][(1q2n)/(1q2)]

10-5

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Forsufficientdiversification,wechooseqsothat:wi2p2/n
Forexample,continuetoassumethatp=0.05andn=1,000.Ifwechoose
q=0.9973,thenwewillsatisfytherequiredcondition.Atthisvalueforq:
w1=0.0029andwn=0.00290.99731,000
Inthiscase,w1isabout15timeswn.Despitethissignificantdeparturefromequal
weighting,thisportfolioisneverthelesswelldiversified.Anyvalueofqbetween0.9973
and1.0resultsinawelldiversifiedportfolio.Asqgetscloserto1,theportfolio
approachesequalweighting.
14.

a.

Assumeasinglefactoreconomy,withafactorriskpremiumEManda(large)set
ofwelldiversifiedportfolioswithbetaP.SupposewecreateaportfolioZby
allocatingtheportionwtoportfolioPand(1w)tothemarketportfolioM.The
rateofreturnonportfolioZis:
RZ=(wRP)+[(1w)RM]
PortfolioZisrisklessifwechoosewsothatZ=0.Thisrequiresthat:
Z=(wP)+[(1w)1]=0w=1/(1P)and(1w)=P/(1P)
SubstitutethisvalueforwintheexpressionforRZ:
RZ={[1/(1P)]RP}{[P/(1P)]RM}
SinceZ=0,then,inordertoavoidarbitrage,RZmustbezero.
Thisimpliesthat:RP=PRM
Takingexpectationswehave:
EP=PEM
ThisistheSMLforwelldiversifiedportfolios.

b.

Thesameargumentcanbeusedtoshowthat,inathreefactormodelwithfactor
riskpremiumsEM,E1andE2,inordertoavoidarbitrage,wemusthave:
EP=(PMEM)+(P1E1)+(P2E2)
ThisistheSMLforathreefactoreconomy.

10-6

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

15.

a.

TheFamaFrench(FF)threefactormodelholdsthatoneofthefactorsdriving
returnsisfirmsize.Anindexwithreturnshighlycorrelatedwithfirmsize(i.e.,
firmcapitalization)thatcapturesthisfactorisSMB(SmallMinusBig),thereturn
foraportfolioofsmallstocksinexcessofthereturnforaportfoliooflargestocks.
ThereturnsforasmallfirmwillbepositivelycorrelatedwithSMB.Moreover,the
smallerthefirm,thegreateritsresidualfromtheothertwofactors,themarket
portfolioandtheHMLportfolio,whichisthereturnforaportfolioofhighbook
tomarketstocksinexcessofthereturnforaportfoliooflowbooktomarket
stocks.Hence,theratioofthevarianceofthisresidualtothevarianceofthereturn
onSMBwillbelargerand,togetherwiththehighercorrelation,resultsinahigh
betaontheSMBfactor.

b. ThisquestionappearstopointtoaflawintheFFmodel.Themodelpredictsthat
firmsizeaffectsaveragereturns,sothat,iftwofirmsmergeintoalargerfirm,then
theFFmodelpredictsloweraveragereturnsforthemergedfirm.However,there
seemstobenoreasonforthemergedfirmtounderperformthereturnsofthe
componentcompanies,assumingthatthecomponentfirmswereunrelatedandthat
theywillnowbeoperatedindependently.Wemightthereforeexpectthatthe
performanceofthemergedfirmwouldbethesameastheperformanceofa
portfoliooftheoriginallyindependentfirms,buttheFFmodelpredictsthatthe
increasedfirmsizewillresultinloweraveragereturns.Therefore,thequestion
revolvesaroundthebehaviorofreturnsforaportfolioofsmallfirms,comparedto
thereturnforlargerfirmsthatresultfrommergingthosesmallfirmsintolarger
ones.Hadpastmergersofsmallfirmsintolargerfirmsresulted,onaverage,inno
changeintheresultantlargerfirmsstockreturncharacteristics(comparedtothe
portfolioofstocksofthemergedfirms),thesizefactorintheFFmodelwould
havefailed.
Perhapsthereasonthesizefactorseemstohelpexplainstockreturnsisthat,when
smallfirmsbecomelarge,thecharacteristicsoftheirfortunes(andhencetheir
stockreturns)changeinasignificantway.Putdifferently,stocksoflargefirms
thatresultfromamergerofsmallerfirmsappearempiricallytobehavedifferently
fromportfoliosofthesmallercomponentfirms.Specifically,theFFmodel
predictsthatthelargefirmwillhaveasmallerriskpremium.Noticethatthis
developmentisnotnecessarilyabadthingforthestockholdersofthesmaller
firmsthatmerge.Thelowerriskpremiummaybedue,inpart,totheincreasein
valueofthelargerfirmrelativetothemergedfirms.

10-7

Chapter 10 - Arbitrage Pricing Theory and Multifactor Models of Risk and Return

CFAPROBLEMS
1.

a.

Thisstatementisincorrect.TheCAPMrequiresameanvarianceefficientmarket
portfolio,butAPTdoesnot.

b.

Thisstatementisincorrect.TheCAPMassumesnormallydistributedsecurity
returns,butAPTdoesnot.

c.

Thisstatementiscorrect.

2.

b.

SincePortfolioXhas=1.0,thenXisthemarketportfolioandE(RM)=16%.
UsingE(RM)=16%andrf=8%,theexpectedreturnforportfolioYisnot
consistent.

3.

d.

4.

c.

5.

d.

6.

c.

7.

d.

8.

d.

Investorswilltakeonaslargeapositionaspossibleonlyifthemispricing
opportunityisanarbitrage.Otherwise,considerationsofriskanddiversification
willlimitthepositiontheyattempttotakeinthemispricedsecurity.

10-8