Chapter 11: An Alternative View of Risk and Return:

The Arbitrage Pricing Theory

11.1

Real GNP was higher than anticipated. Since returns are positively related to the
level of GNP, returns should rise based on this factor.
Inflation was exactly the amount anticipated. Since there was no surprise in this
announcement, it will not affect Lewis-Striden returns.
Interest Rates are lower than anticipated. Since returns are negatively related to
interest rates, the lower than expected rate is good news. Returns should rise due to
interest rates.
The Presidents death is bad news. Although the president was expected to retire,
his retirement would not be effective for six months. During that period he would still
contribute to the firm. His untimely death mean that those contributions would not be
made. Since he was generally considered an asset to the firm, his death will cause
returns to fall.
The poor research results are also bad news. Since Lewis-Striden must continue to
test the drug, it will not go into production as early as expected. The delay will affect
expected future earnings, and thus it will dampen returns now.
The research breakthrough is positive news for Lewis Striden. Since it was
unexpected, it will cause returns to rise.
The competitors announcement is also unexpected, but it is not a welcome
surprise. This announcement will lower the returns on Lewis-Striden.
Systematic risk is risk that cannot be diversified away through formation of a
portfolio. Generally, systematic risk factors are those factors that affect a large
number of firms in the market, however, those factors will not necessarily affect all
firms equally. The systematic factors in the list are real GNP, inflation and interest
rates.
Unsystematic risk is the type of risk that can be diversified away through portfolio
formation. Unsystematic risk factors are specific to the firm or industry. Surprises in
these factors will affect the returns of the firm in which you are interested, but they
will have no effect on the returns of firms in a different industry and perhaps little
effect on other firms in the same industry. For Lewis-Striden, the unsystematic risk
factors are the presidents ability to contribute to the firm, the research results and the
competitor.

11.2

a.

Let m = systematic risk portion of return:

m 1F1 2 F2 3 F3

0.042 4, 480 - 4, 416 1.4 4.3% - 3.1% - 0.67 11.8% - 9.5%

0.53%

b.

Let = the unsystematic portion of risk, since the news was only about this firm:

2.6%

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c.

Total Return = Expected return, plus 2 the components of unexpected return: the
systematic risk portion of return and the unsystematic portion:
R R m
9.5% .53% 2.6%
6.37%

11.3

a.

Let m = systematic risk portion of return:

m 2.04 4.8% 3.5% 1.4 15.2% 14.0%
0.372%

b.

Let = the unsystematic portion of risk:

0.36% 27 23
1.44%
c.

Total Return:
R R m
10.0% 0.37% 1.44%
11.81%

11.4

a.

The market model is specified by :

R R Rm Rm
so applying that to each Stock:
Stock A:
RA RA A Rm Rm A

10.5% 1.2 Rm 14.2% A

Stock B:
RB RB Rm Rm B

13.0% 0.98 Rm 14.2% B

Stock C:
RC RC C Rm Rm C
15.7% 1.37( Rm 14.2%) C

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11.4

(continued)
b.

Since we don't have the actual market return or unsystematic risk, we will get a
formula with those values as unknowns:
RP 0.30 RA 0.45RB 0.25 RC
0.30 10.5% 1.2 Rm 14.2% A
0.45 13.0% 0.98 Rm 14.2% B
0.25 15.7% 1.37 Rm 14.2% c

0.30 10.5% 0.45 13% 0.25 15.7%

0.30 1.2 0.45 0.98 0.25 1.37 Rm 14.2%

0.30 A 0.45 B 0.25 c

12.925% 1.1435 Rm 14.2% 0.30 A 0.45 B 0.25 C

c.

Now, continuing with the Market Model (as in part a), when Rm =15%, and all i = 0 :
i.returns of individual stocks:
RA 10.5% 1.2(15% 14.2%)
11.46%
RB 13% 0.98(15% 14.2%)
13.78%
RC 15.7% 1.37 15% 14.2%
16.8%
ii. return of the portfolio:
R p 12.925% 1.1435(15% 14.2%)
13.84%
Alternate Solution for return on portfolio, where X i is the weight in the portfolio
of stock i:
R p X a Ra X b Rb X c Rc
.3 11.46 .45 13.78 .25 16.8
13.84

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11.5

a.

Since five stocks have the same expected returns and the same betas, the portfolio
also has the same expected return and beta. However, the unsystematic risks might
be different:
R p 11.0 0.84 F1 1.69 F2

1
1 2 3 4 5
5

b.
1
1 2 3 4 5
5
1
1
As N ,
0, but j s are finite, so
1 2 3 4 5 0
N
N
Thus, R p 11.0 0.84 F1 1.69 F2
R p 11.0 0.84 F1 1.69 F2

11.6

To determine which investment investor would prefer, you must compute the
variance of portfolios created by many stocks from either market. Note, because you
know that diversification is good, it is reasonable to assume that once an investor
chose the market in which he or she will invest, he or she will buy many stocks in
that market.
Known:
EF 0 and 0.1
E 0 and i 0.2 for all i.
Assume:
The weight of each stock is 1/N;
that is, X i 1/ N for all i.
If a portfolio is composed of N stocks each forming 1/N proportion of the portfolio,
the return on the portfolio is 1/N times the sum of the returns on the N stocks.
To find the variance of the respective portfolios in the 2 markets, we need to use the
definition of variance from Statistics:
Var ( x) E x E x

In our case:

Var ( R p ) E R p E R p

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11.6

(continued)

Note however, to use this, first we must find R p and E R p . So, using the
assumption about equal weights and then substituting in the known equation for Ri :
1
N
1

RP

0.1 F
i

0.1 F

1
N

Also, recall from Statistics a property of Expected Value:

if: Z% aX% Y%
%X%, and Y%are random variables, then
where a is a constant, and Z,

E Z% E (a ) E X% E Y%
and
E a a .

Now use the above to find E R p :

1

E RP E 0.1 F i
N

1
0.1 E F
E i
N
1
0.1 0
0
N
0.1

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11.6

(continued)
Next, substitute both of these results into the original equation for variance:
Var RP E RP E RP

.01
E 0.1 F
N

E F

E 2 F 2 2 F
N

2 s 2 s 2 i 1
N

i 0.1

( ) 2

1
Cov i , j
N

Finally, since we can have as many stocks in each market as we want,

1
0,
in the limit, as N ,
N
so we get:

Var R p 2 s 2 Cov i , j

and since Cov i , j i j Corr i , j , and the problem states that 1 2 .1

Var R p 2 s 2 1 2 Corr i , j

2 0.01 0.04Corr i , j

So now, summarize what we have so far:

R1i 0.10 1.5 F 1i
R2i 0.10 0.5F 2i

Var R 0.0225 0.04Corr
Var R 0.0025 0.04Corr
E R1 p E R2 P 0.1

1p

1i , 1 j

2P

2i , 2 j

and finally we can begin answering the questions a, b, & c for various values of the
correlations:

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11.6

(continued)
a.

Substitute Corr 1i , 1 j Corr 2i , 2 j 0 into the respective variance formulas:

Var R 0.00225
Var R1 p 0.0225
2p

Since Var R1 p Var R2 p , (and expected returns are equal) a risk averse investor
will prefer to invest in the second market.

b.

Corr 1i , 1 j 0.9 and Corr 2i , 2 j 0

Var R 0.0585

Var R1 p 0.0225 0.04 0.9

1p

Var R2 P 0.0025 0.04 0

Var R2 p 0.0025

Since Var R1 p Var R2 p , a risk averse investor will prefer to invest in the second
market.
c.

Corr 1i , 1 j 0 and Corr 2i , 2 j 0.5

Var R 0.0225

Var R1 p 0.0225 0.04 0

1p

Var R2 P 0.0025 0.04 0.5

Var R2 p 0.0225

Since Var R1 p Var R2 p , a risk averse investor will be indifferent between

investing in the two markets.
d.

Since the expected returns are equal, indifference implies that the variances of the
portfolios in the two markets are also equal. So, set the variance equations equal, and
solve for the correlation of one market in terms of the other:

0.0025 0.04Corr
Corr , 0.5

Var R1 p Var R2 p

0.0225 0.04Corr 1i , 1 j

Corr 2i , 2 j

1i

1j

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2i , 2 j

Therefore, for any set of correlations that have this relationship (as found in part c), a
risk averse investor will be indifferent between the two markets.
11.7

a.

In order to find standard deviation (notated here, s), you must first find the Variance,
since s Var . Recall from Statistics a property of Variance:
if: Z% aX% Y%
%X%, and Y%are random variables, then
where a is a constant, and Z,

Var Z% a 2Var X% Var Y%

and
Var a 0 .
The problem states that return-generation can be described by:
Ri ,t i i Rm i ,t
Realize that Ri ,t , Rm , and i ,t are random variables, and i and i are constants.
Then, apply the above properties to this model, and you get:

Var R j i 2Var Rm Var i

and now find s for each asset (percents have been converted here to decimal*):
s A2 0.7 2 0.0121 0.01 0.015929
s A 0.015929 .1262 12.62%

sB2 1.22 0.0121 0.0144 0.031824

sB 0.031824 0.1784 17.84%
sc2 1.52 0.0121 0.0225 0.049725
sC 0.049725 0.2230 22.30%

*Note that because of taking the square root, there is potential here for getting
confused about the percent. Keep in mind that "percent" is only for the convenience
of presentation. It is always a good idea to convert to decimal before doing
calculations, and do your work in decimals. Then you can convert back to percent
for the final answer.

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11.7

(continued)
b.i:

From above formula for variance, note that as N ,

Var j

0 , so you get:

Var R i i 2 Var R m
So, the variances for the assets are (no confusion about % here, so you can just stay
in %):
s A2 0.7 2 1.21 0.5929%
s 2B 1.22 1.21 1.7424%
sC2 1.52 1.21 2.7225%

b.ii.

Use the model : Ri RF Rm RF i , which is the CAPM (or APT Model when
there is one factor and that factor is the Market).
RA 3.3 (10.6 3.3)(0.7) 8.41%
RB 3.3 (10.6 3.3)(1.2) 12.06%
RC 3.3 (10.6 3.3)(1.5) 14.25%
Compare these results for expected asset returns as per CAPM or APT with the
expected returns given in the table. This shows that assets A & B are accurately
priced, but asset C is overpriced (the model shows the return should be higher).
Thus, rational investors will not hold asset C.

b.iii.

If short selling is allowed, rational investors will sell short asset C, causing the price
of asset C to decrease until no arbitrage opportunity exists. In other words, the price
of asset C should decrease until the return becomes 14.25%.

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11.8

a.

Let

X 1 the proportion of Security 1 in the portfolio and

X 2 the proportion of Security 2 in the portfolio

and note that since the weights must sum to 1.0,

X1 1 X 2 .
Recall from Chapter 10 that the beta for a portfolio (or in this case the beta for a
factor) is the weighted average of the security betas, so

p1 X 1 11 X 2 21
X 1 11 1 X 1 21
Now, apply the condition given in the hint that the return of the portfolio does not
depend on F1 . This means that the portfolio beta for that factor will be 0:

p1 0 X 1 11 1 X 1 21
0 X 1 1.0 (1 X 1 )(0.5)
and solving for X 1 and X 2 :
X 1 1
X2 2
Thus, sell short Security 1 and buy Security 2.
To find the expected return on that portfolio, use
R p X 1 R1 X 2 R2
so applying the above:

E R p 1 20% 2 20% 20%

p 2 1 1.5 2 2 2.5

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11.8

(continued)
b.

Following the same logic as in part a, we have

p1 0 X 3 31 1 X 3 41
0 X 3 1.0 (1 X 3 )(1.5)
and
X3 3
X 4 2
Thus, sell short Security 4 and buy Security 3. Then,

E R p 3 10% 2 10% 10%

p 2 3 0.5 2 0.75 0

Note that since both p1 and p 2 are 0, this is a risk free portfolio!
c.

The portfolio in part b provides a risk free return of 10%, which is higher than the 5%
return provided by the risk free security. To take advantage of this opportunity,
borrow at the risk free rate of 5% and invest the funds in a portfolio built by selling
short security four and buying security three with weights (3,-2) as in part b.

d.

First assume that the risk free security will not change. The price of security four
(that everyone is trying to sell short) will decrease, and the price of security three
(that everyone is trying to buy) will increase. Hence the return of security four will
increase and the return of security three will decrease.
The alternative is that the prices of securities three and four will remain the same, and
the price of the risk-free security drops until its return is 10%.
Finally, a combined movement of all security prices is also possible. The prices of
security four and the risk-free security will decrease and the price of security three
will increase until the opportunity disappears.

E Rj
20%

10%
5%

12 i1 0
0

2.5

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