Arbitrage Pricing Theory and Multifactor Models of Risk and Return

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Arbitrage Pricing Theory and Multifactor Models of Risk and Return Chapter 11

Single Factor Model Returns on a security come from two sources Common macro-economic factor Firm specific events Possible common macro-economic factors Gross Domestic Product Growth Interest Rates

Single Factor Model Equation Ri = E(ri) + Betai (F) + ei Ri = Return for security i Betai = Factor sensitivity or factor loading or factor beta F = Surprise in macro-economic factor (F could be positive, negative or zero) ei = Firm specific events

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 Model Equation Ri = E(ri) + BetaGDP (GDP) + BetaIR (IR) + ei Ri = Return for security i BetaGDP= Factor sensitivity for GDP BetaIR = Factor sensitivity for Interest Rate ei = Firm specific events

Multifactor SML Models E(r) = rf + BGDPRPGDP + BIRRPIR BGDP = Factor sensitivity for GDP RPGDP = Risk premium for GDP BIR = Factor sensitivity for Interest Rate RPIR = Risk premium for GDP

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.

APT & Well-Diversified Portfolios rP = E (rP) + bPF + eP F = some factor For a well-diversified portfolio: eP approaches zero Similar to CAPM

Portfolios and Individual Security E(r)% Portfolio Individual Security

Disequilibrium Example E(r)% 10 A D 7 6 C Risk Free 4 Beta for F .5 1.0

Disequilibrium Example Short Portfolio C Use funds to construct an equivalent risk higher return Portfolio D. D is comprised of A & Risk-Free Asset Arbitrage profit of 1%

APT with Market Index Portfolio E(r)% M [E(rM) - rf] Market Risk Premium Risk Free Beta (Market Index) 1.0

APT and CAPM Compared 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.