RWJ Chapter 12

An Alternative view of Risk and

return
Arbitrage Pricing Theory
Arbitrage - arises if an investor can construct a zero
investment portfolio with a sure profit.
Since no investment is required, an investor can
create large positions to secure large levels of profit.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.

Arbitrage Pricing Theory
The return on any security consists of two parts.
First the expected returns
Second is the unexpected or risky returns.
A way to write the return on a stock in the coming
month is:
return the of part unexpected the is
return the of part expected the is
where
U
R
U R R
Arbitrage Pricing Theory
Any announcement can be broken down into two
parts, the anticipated or expected part and the
surprise or innovation:
Announcement = Expected part + Surprise.
The expected part of any announcement is part of
the information the market uses to form the
expectation, R of the return on the stock.
The surprise is the news that influences the
unanticipated return on the stock, U.


Risk: Systematic and Unsystematic
A systematic risk is any risk that affects a large number
of assets, each to a greater or lesser degree.
An unsystematic risk is a risk that specifically affects a
single asset or small group of assets.
Unsystematic risk can be diversified away.
Examples of systematic risk include uncertainty about
general economic conditions, such as GNP, interest
rates or inflation.
On the other hand, announcements specific to a
company, such as a gold mining company striking gold,
are examples of unsystematic risk.

Risk: Systematic and Unsystematic
Systematic Risk; m
Nonsystematic Risk;
n

Total risk; U
We can break down the risk, U, of holding a stock into two
components: systematic risk and unsystematic risk:
risk ic unsystemat the is
risk systematic the is
where
becomes

m
m R R
U R R



Systematic Risk and Betas
The beta coefficient, b, tells us the response of
the stocks return to a systematic risk.
In the CAPM, b measured the responsiveness of
a securitys return to a specific risk factor, the
return on the market portfolio.
) (
) (
2
,
M
M i
i
R
R R Cov

b
We shall now consider many types of systematic risk.
Systematic Risk and Betas
For example, suppose we have identified three
systematic risks on which we want to focus:
1. Inflation
2. GDP growth
3. The dollar-pound spot exchange rate, S($,)
Our model is:
risk ic unsystemat the is
beta rate exchange spot the is
beta GDP the is
beta inflation the is

F F F R R
m R R
S
GDP
I
S S GDP GDP I I


Systematic Risk and Betas: Example
Suppose we have made the following
estimates:
1. b
I
= -2.30
2. b
GDP
= 1.50
3. b
S
= 0.50.
Finally, the firm was able to attract a
superstar CEO and this unanticipated
development contributes 1% to the return.
F F F R R
S S GDP GDP I I

% 1
% 1 50 . 0 50 . 1 30 . 2
S GDP I
F F F R R
Systematic Risk and Betas: Example
We must decide what surprises took place in the
systematic factors.
If it was the case that the inflation rate was
expected to be by 3%, but in fact was 8%
during the time period, then
F
I
= Surprise in the inflation rate
= actual expected
= 8% - 3%
= 5%
% 1 50 . 0 50 . 1 30 . 2
S GDP I
F F F R R
% 1 50 . 0 50 . 1 % 5 30 . 2
S GDP
F F R R
Systematic Risk and Betas: Example
If it was the case that the rate of GDP growth
was expected to be 4%, but in fact was
1%, then
F
GDP
= Surprise in the rate of GDP growth
= actual expected
= 1% - 4%
= -3%
% 1 50 . 0 50 . 1 % 5 30 . 2
S GDP
F F R R
% 1 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2
S
F R R
Systematic Risk and Betas: Example
If it was the case that dollar-pound spot
exchange rate, S($,), was expected to
increase by 10%, but in fact remained
stable during the time period, then
F
S
= Surprise in the exchange rate
= actual expected
= 0% - 10%
= -10%
% 1 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2
S
F R R
% 1 %) 10 ( 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 R R
Systematic Risk and Betas: Example
Finally, if it was the case that the expected
return on the stock was 8%, then
% 1 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2
S
F R R
% 12
% 1 %) 10 ( 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 % 8


R
R
% 8 R
Portfolios and Factor Models
Now let us consider what happens to portfolios of stocks
when each of the stocks follows a one-factor model.
We will create portfolios from a list of N stocks and will
capture the systematic risk with a 1-factor model.
The i
th
stock in the list have returns:
i i
i
i
F R R
Relationship Between the Return on
the Common Factor & Excess Return
Excess
return
The return on the factor F

i

i i
i
i
F R R
If we assume
that there is no
unsystematic
risk, then
i
= 0
Relationship Between the Return on
the Common Factor & Excess Return
Excess
return
The return on the factor F

If we assume
that there is no
unsystematic
risk, then
i
= 0
F R R
i
i
i

Relationship Between the Return on
the Common Factor & Excess Return
Excess
return
The return on the factor F

Different
securities will
have different
betas
0 . 1
B

50 . 0
C

5 . 1
A

Portfolios and Diversification

We know that the portfolio return is the
weighted average of the returns on the
individual assets in the portfolio:
N N i i P
R X R X R X R X R
2 2 1 1
) (
) ( ) (
2 2
2
2 1 1
1
1
N N
N
N
P
F R X
F R X F R X R

N N N N
N
N
P
X F X R X
X F X R X X F X R X R

2 2 2 2
2
2 1 1 1 1
1
1
i i
i
i
F R R
Portfolios and Diversification
The return on any portfolio is determined by
three sets of parameters:

In a large portfolio, the third row of this equation
disappears as the unsystematic risk is diversified away.
N
N P
R X R X R X R
2
2
1
1
1. The weighed average of expected returns.
F X X X
N N
) (
2 2 1 1

2. The weighted average of the betas times the factor.
N N
X X X
2 2 1 1
3. The weighted average of the unsystematic risks.
Portfolios and Diversification
So the return on a diversified portfolio is
determined by two sets of parameters:
1. The weighed average of expected returns.
2. The weighted average of the betas times the
factor F.
F X X X
R X R X R X R
N N
N
N P
) (
2 2 1 1
2
2
1
1

In a large portfolio, the only source of uncertainty is the

portfolios sensitivity to the factor.
Betas and Expected Returns
The return on a diversified portfolio is the sum of
the expected return plus the sensitivity of the
portfolio to the factor.
F X X R X R X R
N N
N
N P
) (
1 1
1
1

F R R
P
P
P

N
N
P
R X R X R
1
1
that Recall
N N P
X X
1 1
and
P
R
P

Relationship Between b & Expected

Return
If shareholders are ignoring unsystematic risk, only
the systematic risk of a stock can be related to its
expected return.
F R R
P
P
P

Relationship Between b & Expected
Return
E
x
p
e
c
t
e
d

r
e
t
u
r
n

b

F
R
A
B
C
D
SML
) (
F
P
F
R R R R
The Capital Asset Pricing Model and
the Arbitrage Pricing Theory
APT applies to well diversified portfolios and
not necessarily to individual stocks.
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML.
APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio.
APT can be extended to multifactor models.

Empirical Approaches to Asset Pricing
Both the CAPM and APT are risk-based models.
There are alternatives.
Empirical methods are based less on theory and
more on looking for some regularities in the
historical record.
Be aware that correlation does not imply
causality.
Related to empirical methods is the practice of
classifying portfolios by style e.g.
Value portfolio
Growth portfolio
Summary and Conclusions
The APT assumes that stock returns are
generated according to factor models such as:


F F F R R
S S GDP GDP I I

As securities are added to the portfolio, the unsystematic
risks of the individual securities offset each other. A fully
diversified portfolio has no unsystematic risk.
The CAPM can be viewed as a special case of the APT.
Empirical models try to capture the relations between
returns and stock attributes that can be measured directly
from the data without appeal to theory.