1. An Alternative View of Risk and Return: The Arbitrage Pricing Theory Chapter 12 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 12-1 Key Concepts and Skills  Discuss the relative importance of systematic and unsystematic risk in determining a portfolio’s return  Compare and contrast the CAPM and Arbitrage Pricing Theory

3. 12-2 Chapter Outline 12.1 Introduction 12.2 Systematic Risk and Betas 12.3 Portfolios and Factor Models 12.4 Betas and Expected Returns 12.5 The Capital Asset Pricing Model and the Arbitrage Pricing Theory 12.6 Empirical Approaches to Asset Pricing

4. 12-3 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.

5. 12-4 Total Risk  Total risk = systematic risk + unsystematic risk  The standard deviation of returns is a measure of total risk.  For well-diversified portfolios, unsystematic risk is very small.  Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.

6. 12-5 Risk: Systematic and Unsystematic Systematic Risk: m Nonsystematic Risk:  n 22 Total risk We can break down the total risk of holding a stock into two components: systematic risk and unsystematic risk: 

7. 12-6 12.2 Systematic Risk and Betas  The beta coefficient, , tells us the response of the stock’s return to a systematic risk.  In the CAPM,  measures the responsiveness of a security’s return to a specific risk factor, the return on the market portfolio. We shall now consider other types of systematic risk.

8. 12-7 Systematic Risk and Betas  For example, suppose we have identified three systematic risks: inflation, GNP growth, and the dollar-euro spot exchange rate, S($,€).  Our model is:

9. 12-8 Systematic Risk and Betas: Example  Suppose we have made the following estimates:   I = -2.30   GNP = 1.50   S = 0.50  Finally, the firm was able to attract a “superstar” CEO, and this unanticipated development contributes 1% to the return.

10. 12-9 Systematic Risk and Betas: Example We must decide what surprises took place in the systematic factors. If it were the case that the inflation rate was expected to be 3%, but in fact was 8% during the time period, then: F I = Surprise in the inflation rate = actual – expected = 8% – 3% = 5%

11. 12-10 Systematic Risk and Betas: Example If it were the case that the rate of GNP growth was expected to be 4%, but in fact was 1%, then: F GNP = Surprise in the rate of GNP growth = actual – expected = 1% – 4% = – 3%

12. 12-11 Systematic Risk and Betas: Example If it were the case that the dollar-euro 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%

13. 12-12 Systematic Risk and Betas: Example Finally, if it were the case that the expected return on the stock was 8%, then:

14. 12-13 12.3 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 has return:

15. 12-14 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.

16. 12-15 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.

17. 12-16 Relationship Between the Return on the Common Factor & Excess Return Excess return The return on the factor F Different securities will have different betas.

18. 12-17 Portfolios and Diversification  We know that the portfolio return is the weighted average of the returns on the individual assets in the portfolio:

19. 12-18 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. 1.The weighted average of expected returns. 2.The weighted average of the betas times the factor. 3.The weighted average of the unsystematic risks.

20. 12-19 Portfolios and Diversification So the return on a diversified portfolio is determined by two sets of parameters: 1. The weighted average of expected returns. 2. The weighted average of the betas times the factor F. In a large portfolio, the only source of uncertainty is the portfolio’s sensitivity to the factor.

21. 12-20 12.4 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.

22. 12-21 Relationship Between  & Expected Return  If shareholders are ignoring unsystematic risk, only the systematic risk of a stock can be related to its expected return.

23. 12-22 Relationship Between  & Expected Return Expected return  A B C D SML

24. 12-23 12.5 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.

25. 12-24 12.6 Empirical Approaches to Asset Pricing  Both the CAPM and APT are risk-based models.  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

26. 12-25 Quick Quiz  Differentiate systematic risk from unsystematic risk. Which type is essentially eliminated with well diversified portfolios?  Define arbitrage.  Explain how the CAPM be considered a special case of Arbitrage Pricing Theory?