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Chapter 3: The arbitrage pricing theory

Chapter 3: The arbitrage pricing theory

Aim of the chapter
The aim of this chapter is to derive arbitrage pricing theory, an alternative to the capital asset pricing model, enabling us to price financial assets.

Learning objectives
At the end of this chapter, and having completed the essential reading and activities, you should be able to: understand single-factor and multi-factor model representations derive factor-replicating portfolios from a set of asset returns understand the notion of arbitrage strategies and that well-functioning financial markets should be arbitrage-free derive arbitrage pricing theory and calculate expected returns using the pricing formula.

Essential reading
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston, Mass.; London: McGraw-Hill, 2002) Chapter 6.

Further reading
Brealey, R., S. Myers and F. Allen Principles of Corporate Finance. (Boston, Mass.; London: McGraw-Hill, 2008) Chapter 9. Chen, N-F. Some Empirical Tests of the Theory of Arbitrage Pricing, The Journal of Finance 38(5) 1983, pp.13931414. Chen, N-F., R. Roll and S. Ross Economic Forces and the Stock Market, Journal of Business 59, 1986, pp.383403. Copeland, T., J. Weston and K. Shastri Financial Theory and Corporate Policy. (Reading, Mass.; Wokingham: Addison-Wesley, 2005) Chapter 6.

The arbitrage pricing theory is an alternative paradigm used to calculate equilibrium expected returns on financial assets. As its name suggests, it rests on the notion that well-functioning financial markets should be arbitrage-free. This, using a factor model of asset returns, implies restrictions on the relationships between asset returns and generates an equilibrium pricing relationship.

The arbitrage pricing theory (APT) developed in this chapter gives an alternative to the CAPM as a method to compute the expected returns on stocks. The basis for the APT is a factor model of stock returns, and we will define and discuss these models first. From there we will demonstrate how to derive expected returns using the idea that the returns on stocks, which are exposed to a common set of factors, must be mutually consistent, given each stocks sensitivity to each factor.


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To give structure to what we mean by mutually consistent, we need to define the notion of an arbitrage. An arbitrage strategy can be one of two types. It could involve investment in a set of assets (both buying and selling) that yields an immediate, positive cash inflow (i.e. the receipts from our sales exceed the cost of our purchases) and, further, is guaranteed not to make a loss tomorrow. Faced by an investment strategy with this payoff structure, any investor who prefers more to less wealth would try to invest on an infinite scale. It could be an investment strategy that is costless today but guarantees positive future returns. This is akin to receiving something for nothing, and again, sensible investors would capitalise on the possibility by investing as much as possible. The idea that underpins the APT is that investment situations, such as those described above, should not be permitted in well-functioning financial markets. Then, if financial markets do not permit the existence of arbitrage strategies, this places restrictions on the relationships between the expected returns on assets given the factor structure underlying returns. We will explain further in later sections of this chapter.

Single-factor models
Before using the notion of absence of arbitrage to provide pricing relations, we need a basis for the generation of stock returns. Within the context of the APT, this basis is given by the assumption that the population of stock returns is generated by a factor model. The simplest factor model, given below, is a one-factor model: ri = i + i F + i E(i) = 0. (3.1) In equation 3.1, the returns on stock i are related to two main components: 1. The first of these is a component that involves the factor F. This factor is posited to affect all stock returns, although with differing sensitivities. The sensitivity of stock is return to F is i. Stocks that have small values for this parameter will react only slightly as F changes, whereas when i is large, variations in F cause very large movements in the return on stock i. As a concrete example, think of F as the return on a market index (e.g. the S&P-500 or the FTSE-100), the variations in which cause variations in individual stock returns. Hence, this term causes movements in individual stock returns that are related. If two stocks have positive sensitivities to the factor, both will tend to move in the same direction. 2. The second term in the factor model is a random shock to returns, which is assumed to be uncorrelated across different stocks. We have denoted this term i and call it the idiosyncratic return component for stock i. An important property of the idiosyncratic component is that it is also assumed to be uncorrelated with F, the common factor in stock returns. In statistical terms we can write the conditions on the idiosyncratic component as follows: Cov(i , j) = 0 i j Cov(i , F) = 0 i

An example of such an idiosyncratic stock return might be the unexpected departure of a firms CEO or an unexpected legal action brought against the company in question. The partition of returns implied by equation 3.1 implies that all common variation in stock returns is generated by movements in F (i.e. the correlation between the returns on stocks i and j derives solely from F). As the idiosyncratic components are uncorrelated across assets they do not bring about covariation in stock price movements.

Chapter 3: The arbitrage pricing theory

Application exercise Consider an economy in which the risk-free rate of return is 4% and the expected rate of return on the market index is 9%. The variance of the return on the market index is 20%. Two portfolios A and B have expected return 7% and 10%, and variance 20% and 50%, respectively. a) Work out the portfolios beta coefficients. According to the CAPM: E(rA) = rF + A [E(rM) rF] and E(rB) = rF + B [E(rM) rF]. Hence: A = [E(rA) rF]/[E(rM) rF] = (7% 4%)/(9% 4%) = 0.6 B = [E(rB) rF]/[E(rM) rF] = (10% 4%)/(9% 4%) = 1.2. b) The risk of a portfolio can be decomposed into market risk and idiosyncratic risk. What are the proportions of market risk and idiosyncratic risk for the two portfolios A and B? From the market model: rA = A + A rM + A rB = B + B rM + B with cov(rM, A) = cov(rM, B) = 0. It hence follows that the variance of portfolio As returns, 2A, has two components, systematic and idiosyncratic risk: 2A = 2A 2M + 2A. Similarly: 2B = 2B 2M + 2B. The proportion of systematic risk for A is hence 2A 2M / 2A = (0.6)2*20%/20% = 36%. The proportion of idiosyncratic risk for A is hence 1 [2A 2M / 2A] = 64%. The proportion of systematic risk for B is hence 2B 2M / 2B = (1.2)2*20%/50% = 58%. The proportion of idiosyncratic risk for B is hence 1 [2B 2M / 2B] = 42%. Portfolio B is much riskier than portfolio A as the variance of its returns is 50% compared with 20% for A. The main reason why it is riskier is that it is much more sensitive to the return of the market index than portfolio A as its beta is 1.2 compared with 0.6 for portfolio A. c) Assume the two portfolios have uncorrelated idiosyncratic risk. What is the covariance between the returns on the two portfolios? Cov(rA,rB) = Cov(A +A rM + A, B +B rM + B) = A B 2M = 0.6*1.2*20% = 14%. The returns of portfolios A and B are hence (positively) correlated even though their idiosyncratic return components are not. These returns are positively correlated because they are positively correlated with the returns of the market index.


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Multi-factor models
A generalisation of the structure presented in equation 3.1 posits k factors or sources of common variation in stock returns. ri = i + 1iF1 + 2iF2 + .... + kiFk + i E(i) = 0. (3.2) Again the idiosyncratic component is assumed uncorrelated across stocks and with all of the factors. Further, well assume that each of the factors has a mean of zero. These factors can be thought of as representing news on economic conditions, financial conditions or political events. Note that this assumption implies that the expected return on asset i is just given by the constant in equation 3.2 (i.e. E(ri) = i). Each stock has a complement of factor sensitivities or factor betas, which determine how sensitive the return on the stock in question is to variations in each of the factors. A pertinent question to ask at this point is how do we determine the return on a portfolio of assets given the k-factor structure assumed? The answer is surprisingly simple: the factor sensitivities for a portfolio of assets are calculable as the portfolio weighted averages of the individual factor sensitivities. The following example will demonstrate the point. Example The returns on stocks X, Y, and Z are determined by the following two-factor model: rX = 0.05 + F1 0.5F2 + X rY = 0.03 + 0.75 F1 + 0.5F2 + Y rz = 0.04 + 0.25 F1 0.3F2 + z Given the factor sensitivities in the prior three equations, we wish to derive the factor structure followed by an equally weighted portfolio of the three assets (i.e. a portfolio with one-third of the weights on each of the assets). Following the result mentioned above, all we need to do is form a weighted average of the stock sensitivities on the individual assets. Subscripting the coefficients for the equally weighted portfolio with a p we have: 1 p = (0.05 + 0.03 + 0.04) = 0.04 3 1p = 1 (1 + 0.75 0.25) = 0.5 3 1 (0.5 + 0.5 0.3) = 0.1; 2p = 3 and hence; the factor representation for the portfolio return can be written as: rp = 0.04 + 0.5F1 0.1F2 + p where the final term is the idiosyncratic component in the portfolio return. Activity Using the data given in the previous example, compute the return representation for a portfolio of assets X, Y and Z with portfolio weights 0.25, 0.5 and 0.75. An important implication of the result is the following. Assume a twofactor model, and also assume that we are given the factor representations for three stocks. I can construct a portfolio of these three assets, which has any desired set of factor sensitivities through appropriate choice of the portfolio weights.1 What underlies this result? Well, to illustrate lets use the data from the prior example. Assume I wish to construct a portfolio with a sensitivity of 0.5 on the first factor and a sensitivity of 1 on the second factor. Denoting the portfolio weights on the individual assets by X, Y and Z it must be the case that:

1 In general, if I have a k-factor model I will need k+1 stocks to do this.

Chapter 3: The arbitrage pricing theory

X + 0.75Y 0.25Z = 0.5 0.05X + 0.5Y 0.3Z = 1.

(3.3) (3.4)

Finally, it must also be the case that the portfolio weights add up to unity, so we must also satisfy the following equation: X + Y + Z = 1. Equations 3.3, 3.4 and 3.5 are three equations in three unknowns, and we can find values for the portfolio weights which satisfy all three simultaneously. This illustrates the fact that (as the portfolio factor sensitivities were arbitrarily set at 0.5 and 1) we can derive any constellation of factor sensitivities. A particularly interesting case is when the portfolio is sensitive to one of the factors only. We call this a factor-replicating portfolio and discuss it below.

Broad-based portfolios and idiosyncratic returns

In what follows we will assume that the basic securities that were going to work with are themselves broad-based portfolios. The reason for this is that it allows us to lose the idiosyncratic risk terms associated with single stocks. Why is this the case? Well, consider the idiosyncratic risk term for an equally weighted portfolio of 100 stocks. Call the ith idiosyncratic term i and assume that all idiosyncratic terms have variance 2. The variance of the idiosyncratic element of the portfolio return is then: 100 100 2 100 1 Var (P) = Var ( i ) = Var ( i) = = 2 = 100 . 100 10000 10000 i =1 i =1 Note that, under these assumptions the variance of the idiosyncratic portfolio return is only one-hundredth of the variance of any individual assets idiosyncratic return. In a general case, where one forms an equally weighted portfolio of n assets, the variance of the idiosyncratic term for the portfolio return is n-12. This is a diversification result just like those we used in Chapter 2. The fact that the idiosyncratic returns are uncorrelated with one another means that their influence tends to disappear when one groups assets into large portfolios.

Factor-replicating portfolios
An important application of the technology developed previously in this chapter is the construction of factor-replicating portfolio. A factor-replicating portfolio is a portfolio with unit exposure to one factor and zero exposure to all others. For example, the portfolio replicating factor 1 in model 3.2 would have 1 = 1 and j = 0 for all j = 2 to k. Activity Assume that stock returns are generated by a two-factor model. The returns on three well-diversified portfolios, A, B and C, are given by the following representations: rA = 0.10 F1 0.5F2 rB = 0.08 + 2F1 + F2 rC = 0.05 + 0.5F1 + 0.5F2. Determine the portfolio weights you need to place on A, B and C in order to construct the two factor-replicating portfolios plus a portfolio which has zero exposure to both factors. What are the expected returns of the factor-replicating portfolios and what is the expected return of the risk-free portfolio?


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The question to ask at this point is: why bother constructing factorreplicating portfolios? The reason is as follows. Suppose I want to build a portfolio that has identical factor exposures to a given asset, X. Assume a two-factor world and that asset X has exposure of 0.75 to factor 1 and 0.3 to factor 2. Assume also that I know the two factor-replicating portfolios. Building a portfolio with the same factor exposures as X is now simple. Construct a new portfolio, Y, which has portfolio weight 0.75 on the replicating portfolio for the first factor, portfolio weight 0.3 on the replicating portfolio for the second factor and the rest of the portfolio weight (i.e. a weight of 1 0.75 + 0.3 = 0.55) on the risk-free asset. Via the results on the factor representations of a portfolio of assets and the definition of a factor-replicating portfolio it is easy to see that Y is guaranteed to have identical factor exposures to X. The replication in the preceding paragraph forms the basis for the APT. For absence of arbitrage we require all assets with identical factor exposures to earn the same return. If they did not, then we would have the chance to make unlimited amounts of money. For example, assume that the expected return on the replicating portfolio Y was greater than that on asset X. Then I should short X and buy Y. The risk exposures of the two portfolios are identical and hence risks cancel out and I am left with an excess return that is riskless (i.e. an arbitrage gain). In order to progress, let us introduce some notation. Denote the riskfree rate with rf. Denote the expected return on the ith factor-replicating portfolio with rf + i such that i is the risk premium associated with the ith factor. Again, for simplicity, assume that the world is generated by a two-factor model, and assume that I wish to replicate asset X, which has sensitivity 1X to the first factor and 2X to the second factor. Finally, we will assume that the primary securities being worked with are welldiversified portfolios themselves. Hence, we will ignore any idiosyncratic risk in this derivation. Using the prior argument, to replicate asset Xs factor sensitivities, we construct a portfolio with weight 1X on the first factor-replicating portfolio, weight 2X on the second factor-replicating portfolio and weight 1 1X 2X on the risk-free asset. The expected return of the replicating portfolio is hence: 1X (rf + 1) + 2X (rf + 2) + (1 1X 2X) rf = rf + 1X 1+ 2X 2. (3.6) Hence, using our factor-replicating portfolios we can write the expected return on a portfolio which replicates Xs factor exposures as the risk-free rate plus each factor exposure multiplied by the risk premium on the relevant factor-replicating portfolio.

The arbitrage pricing theory

Consider an arbitrary asset. The previous sub-section tells us that its simple to replicate this assets risk (i.e. its factor exposures) using factorreplicating portfolios. The key to the APT is that absence of arbitrage requires that such a pair of portfolios must have identical expected returns in a financial market equilibrium. If they did not, it would be possible to make unlimited amounts of money without incurring any risk. This implies that the expected return on asset X, rX, must be identical to the expression arrived at in equation 3.6, that is: E(rX) = rf + 1X 1+ 2X 2. (3.7)


Chapter 3: The arbitrage pricing theory

Equation 3.7 is the statement of the APT. The expected return on a financial asset can be written as the risk-free rate plus sum of the assets factor sensitivities multiplied by the factor-risk premiums (which are invariant across assets). If such an expression does not hold at all times, arbitrage opportunities exist. Note the assumptions that are required to achieve this result. First, we require that asset returns are generated by a two-factor (or in general k-factor) model. Second, we assume that arbitrage opportunities cannot exist. Lastly, we assume that enough assets are available such that firm-specific risk washes away when portfolios are formed. Example In the previous two-factor example, we determined the expected returns on the two factor-replicating portfolios. Denoting the expected return on the ith factor-replicating portfolio by E(ri) we have: E(r1) = 8.29% 1 = 8.29 5.14 = 3.15%, E(ri) = 5.14 + 3.151i 3.432i. To check that this works, substitute portfolio Cs (for example) factor sensitivities into the preceding expression. This gives: E(rC) = 5.14 + 3.15 (0.5) 3.43 (0.5) = 5%, and hence, agrees with the expected return implied by the original representation for asset C. Check that the expected returns on assets A and B also come out correctly. To analyse an arbitrage opportunity that might arise in markets, attempt the following Activity. Activity Assume that a new well-diversified portfolio, D, is added to our world. This asset has sensitivities of 3 and 1 to the two factors and an expected return of 15 per cent. Using the equilibrium expected return equation given above, derive the equilibrium expected return on an asset with identical factor exposures to D. Is there now an arbitrage opportunity available? If so, dictate a strategy that could be employed to exploit the arbitrage opportunity. E(r2) = 1.71% 2 = 1.71 5.14 = 3.43%. E(r3) = 5.14%. Hence, the premiums associated with the two factors are: This implies that the expected return on any asset in this world can be written as:

The APT gives us a straightforward, alternative view of the world from the CAPM. The CAPM implies that the only factor that is important in generating expected returns is the market return and, further, that expected stock returns are linear in the return on the market. The APT allows there to be k sources of systematic risk in the economy. Some may reflect macroeconomic factors, like inflation, and interest rate risk, whereas others may reflect characteristics specific to a firms industry or sector. Empirical research has indicated that some of the well-known empirical problems with the CAPM are driven by the fact that the APT is really the proper model of expected return generation. Chen (1983), for example, argues that the size effect found in CAPM studies disappears in a multifactor setting. Chen, Roll and Ross (1986) argue that factors representing default spreads, yield spreads and GDP growth are important in expected return generation. Work in this area is still progressing.

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A reminder of your learning outcomes

Having completed this chapter, and the essential reading and activities, you should be able to: understand single-factor and multi-factor model representations derive factor-replicating portfolios from a set of asset returns understand the notion of arbitrage strategies and that well-functioning financial markets should be arbitrage-free derive arbitrage pricing theory and calculate expected returns using the pricing formula.

Key terms
arbitrage pricing theory factor-replicating portfolio factor sensitivity multi-factor model single-factor model

Sample examination question

1. Assume that stock returns are generated by a two-factor model. The returns on three well-diversified portfolios, A, B and C, are given by the following representations: rA = 0.10 + F1 rB = 0.08 + 2F1 F2 rC = 0.05 0.5F1 + 0.5F2 a) Discuss what the factor representations above imply for the variation and comovement in the three stock returns. Show how the returns of the stocks should be correlated between themselves. b) Find the portfolio weights that one must place on stocks A, B and C to construct pure tracking portfolios for the two factors (i.e. portfolios in which the loading on the relevant factor is +1 and the loadings on all other factors are 0). c) If one was to introduce a new portfolio, D, with loadings of +1 on both of the factors, what would the expected return on D have to be to rule out arbitrage? d) Explain the concepts of idiosyncratic risk and factor risk in the APT. What role does diversification play in the APT?