Lecture 6

Arbitrage Pricing Theory and

Multifactor Models of Risk and
Return

30055 Financial Economics Prof. Petrova

Index vs. Factor Models

Index models decompose stock variability into
market and firm-specific
The return on the market portfolio summarizes the broad
impact of macro factors

Sometimes rather than using a market proxy is useful

to focus directly on the ultimate sources of risk
Useful in risk assessments measuring risk exposure

Factor models allow to describe and quantify

different factors that affect the rate of return on a
security during any period
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Single Factor Model

Returns on a security come from two sources:
Common macro

Constructed to have exp. value of 0.

F is the deviation of the common factor from its expected
value

Firm specific events

Possible common macro-economic factors
Gross Domestic Product Growth
Interest Rates
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Single Factor Model Equation

= ( ) + +

Ri = Excess return on security

i= Factor sensitivity or factor loading or factor beta

F = Surprise in macro-economic factor
(F could be positive or negative but has expected value
of zero)
ei = Firm specific events (zero expected value)
ei assumed uncorrelated among themselves and with F

Factor Model Example

Suppose that F is the news about the state of
the business cycle, measured as the
unexpected change in GDP and that the
consensus is that GDP will increase by 5% next
year. Suppose that stock has a F sensitivity of
1.2. If GDP increases by 3% what would be the
effect on the return on the stock?

Multifactor models
Factors model decomposition to systematic and nonsystematic compelling, but confining to one systematic risk to
a single factor is not
Number of systematic risk sources

GDP
Interest rates
Term structure
Inflation
Employment
Exchange rates

Single-index models assume that all securities have the same

sensitivity to the various macro-factors
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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.

Multifactor (Two-factor) Model

Equation

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

Ri = Excess return for security i

GDP = Factor sensitivity for GDP
IR = Factor sensitivity for Interest Rate
ei = Firm specific events

Interpretation
The expected return on a security is the sum of:
1.The risk-free rate
2.The sensitivity to GDP times the risk
premium for bearing GDP risk
3.The sensitivity to interest rate risk times the
risk premium for bearing interest rate risk

Two-factor Model Example

Consider two firms
Firm A - Regulated power utility in a residential
area
Firm B - An airline

What are the sensitivities of A and B to:

GDP
IR
Is a macro news that the economy will expand bad or
good for A & B?
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Two-factor Model Example

Consider United Airlines
We estimate a two-factor model and find that:
r=.12+1.2GDP - .3IR +e
What is the interpretation of this model?

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A Multifactor SML
Multifactor model a description of the factors
that affect security returns
No theory in the equation
Where does E(r) come from?
E (ri ) = rf + GDP RPGDP + IR RPIR
One difference b/n single and multiple-factor
economy is that a factor risk premium can be
negative
E.g. security with a positive IR beta hedges the value of
portfolio against IR risk
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United Example Continued

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Suppose rf=3%
RPGDP=7%
RPIR=2%
What is E(r)?

Arbitrage Pricing Theory

APT developed by Stephen Ross in 1976
Security returns are described by factor models
There is a large number of securities and sufficient to diversify
firm-specific risk
Well-functioning markets do not allow for persistent arbitrage
opportunities

Arbitrage occurs if there is a zero investment portfolio

with a sure profit.
Since no investment is required, investors can create
large positions to obtain large profits.

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Arbitrage Pricing Theory

Regardless of wealth or risk aversion,
investors will want an infinite position in
the risk-free arbitrage portfolio.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.

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The Law of One Price

If two assets re equivalent in all economically
relevant aspects they should have the same price
Enforced by arbitrageurs

Arbitrageur investor looking for mispriced

securities
Risk arbitrage vs. pure arbitrage
Derivative vs. primitive securities
Derivative securities condition of no-arbitrage leads to
exact pricing
Primitive securities use diversification arguments
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APT & Well-Diversified Portfolios

RP = E (RP) + bPF + eP
F = some factor
For a well-diversified portfolio, eP

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approaches zero as the number of securities in

the portfolio increases
and their associated weights decrease
If the securities in the portfolio are equally
weighted: 2 = 2 2 ( ) = 1/n( 2 ( ))

APT & Well-Diversified Portfolios

RP = E (RP) + bPF
Non-factor risk is diversified away and only
factor risk commands a risk premium in
market equilibrium

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Figure 10.1 Returns as a Function of the

Systematic Factor
rp=10% +1.0*F

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Figure 10.2 Returns as a Function of the

Systematic Factor: An Arbitrage Opportunity
rp=10% +1.0*F

What is the arbitrage opportunity here?

Form an arbitrage strategy and find the riskless payoff.
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Example
Consider a single factor APT. Portfolio A has a
beta of 1.0 and an expected return of 16%.
Portfolio B has a beta of 0.8 and an expected
return of 12%. The risk-free rate of return is
6%. If you wanted to take advantage of an
arbitrage opportunity, you should take a short
position in portfolio __________ and a long
position in portfolio _______.
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Example
Consider the one-factor APT. The variance of
returns on the factor portfolio is 6%. The beta
of a well-diversified portfolio on the factor is
1.1. The variance of returns on the welldiversified portfolio is approximately

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Figure 10.3 An Arbitrage Opportunity

Portfolio with Different Betas

D is composed of .5 in A and .5 in the risk-free asset

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No-Arbitrage Equation of APT

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the APT, the CAPM and the Index

Model
APT
Assumes a welldiversified portfolio,
but residual risk is still
a factor.
Does not assume
investors are meanvariance optimizers.
Uses an observable,
market index
Reveals arbitrage
opportunities
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CAPM
Model is based on an
inherently unobservable
market portfolio.
Rests on mean-variance
efficiency.
The actions of many
small investors restore
CAPM equilibrium.

Multifactor APT
Use of more than a single systematic factor
Requires formation of factor portfolios
What factors?
Factors that are important to performance
of the general economy
What about firm characteristics?

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Two-Factor Model

The multifactor APT is similar to the onefactor case.

= ( ) + 1 1 + 2 2 +

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Two-Factor Model
Track with diversified factor portfolios:
beta=1 for one of the factors and 0 for
all other factors.
The factor portfolios track a particular
source of macroeconomic risk, but are
uncorrelated with other sources of risk.

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Example
Consider the multifactor APT with two factors.
Stock A has an expected return of 17.6%, a
beta of 1.45 on factor 1, and a beta of .86 on
factor 2. The risk premium on the factor 1
portfolio is 3.2%. The risk-free rate of return is
5%. What is the risk-premium on factor 2 if no
arbitrage opportunities exist?

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Fama-French Three-Factor Model

SMB = Small Minus Big (firm size)
HML = High Minus Low (book-to-market ratio)
Are these firm characteristics correlated with
actual (but currently unknown) systematic risk
factors?

Rit = i + iM RMt + iSMB SMBt + iHML HMLt + eit

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The Multifactor CAPM and the APT

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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