FINM3093: Investments

Lecture 5

Dr Sherry Zhou
United International College, Zhuhai

1
Outline
• Arbitrage Pricing Theory (APT) (Textbook Chapter 10)
• Efficient Market Hypothesis (Textbook Chapter 11)

2
Arbitrage Pricing Theory and Multifactor Models:
Overview (Textbook Chapter 10)
• Arbitrage is the exploitation of security mispricing in such a way that
risk-free profits can be earned
• Most basic principle of capital market theory is that well-functioning security
markets rule out arbitrage opportunities
• Generalization of the security market line of the CAPM to gain richer
insight into the risk-return relationship
• Arbitrage pricing theory (APT)

APT CAPM

3
Multifactor Models: A Preview
• Recall stock variability may be decomposed into the following
sources:
• Market (i.e., systemic) risk
• Largely due to macroeconomic events
• Firm-specific (i.e., idiosyncratic) effects
• Risk premiums may depend on correlations with extra-market risk
factors
• E.g., inflation, interest rates, volatility, etc.

4
Factor Models of Security Returns
• Single-factor model of excess returns

𝑅𝑖 = 𝐸 𝑅𝑖 + β𝑖 𝐹 + 𝑒𝑖

𝐸(𝑅𝑖 ) = expected excess return on stock 𝑖

𝐹 = deviation of the common factor from its expected value
β𝑖 = sensitivity of firm 𝑖 to the factor
𝑒𝑖 = nonsystematic components of returns

5
Factor Models of Security Returns
• Extra market sources of risk may arise from several sources
• E.g., uncertainty about interest rates or inflation.

• Multifactor models posit that returns respond to several systematic

risk factors, as well as firm-specific influences
• Useful in risk management applications

6
Factor Models of Security Returns
Ri = E(Ri ) + iGDPGDP + iIR IR + ei
𝑅𝑖 = excess return on security i
β𝐺𝐷𝑃 = sensitivity of returns to GDP
β𝐼𝑅 = sensitivity of returns to interest rates
𝑒𝑖 = nonsystematic components of returns

7
Arbitrage Pricing Theory
• Arbitrage pricing theory (APT) relies on three key propositions:
1. Security returns can be described by a factor model
2. There are sufficient securities to diversify away idiosyncratic risk
3. Well-functioning security markets do not allow for the persistence of
arbitrage opportunities

8
Arbitrage, Risk Arbitrage, and Equilibrium
• Arbitrage opportunity exists when an investor can earn riskless
profits without making a net investment
• E.g., shares of a stock sell for different prices on two different exchanges
• Law of One Price
• Enforced by arbitrageurs; If they observe a violation, they will engage in
arbitrage activity
• This bids up (down) the price where it is low (high) until the arbitrage
opportunity is eliminated

9
Diversification in a Single-Factor Security
Market
• The excess return, Rp, on an n-stock portfolio with weights wi, σ 𝑤𝑖 = 1, is
𝑅𝑃 = 𝐸 𝑅𝑃 + 𝛽𝑃 𝐹 + 𝑒𝑃
where 𝛽𝑃 = σ 𝑤𝑖 𝛽𝑖 , 𝐸 𝑅𝑃 = σ 𝑤𝑖 𝐸 𝑅𝑖 , and 𝑒𝑃 = σ 𝑤𝑖 𝑒𝑖
• The variance of the portfolio can be separated into it systematic and
nonsystematic sources
𝜎𝑃2 = 𝛽𝑃2 𝜎𝐹2 + 𝜎 2 𝑒𝑃 = 𝛽𝑃2 𝜎𝐹2 + ෍ 𝑤𝑖2 𝜎 2 𝑒𝑖

• If the portfolio were equally weighted, 𝑤𝑖 = 1/n, then

2
2
1 𝜎 𝑒𝑖 1 2
𝜎 𝑒𝑃 = ෍ = 𝜎ത 𝑒𝑖
𝑛 𝑛 𝑛
• Firm-specific risk becomes increasingly irrelevant as the portfolio becomes more diversified.

10
Well-Diversified Portfolios
• In a well-diversified portfolio, firm-specific risk becomes negligible, so
that only factor risk remains
• One effect of diversification is that, when n is large, nonsystematic variance
approaches zero
• A well-diversified portfolio is one with each weight small enough that
for practical purposes the nonsystematic variance is negligible
• For a well-diversified portfolio, 𝑅𝑃 = 𝐸 𝑅𝑃 + 𝛽𝑃 𝐹

11
Self-Check Exercise
a. A portfolio is invested in a very large number of shares (n is large).
However, one-half of the portfolio is invested in stock 1, and the
rest of the portfolio is equally divided among the other n – 1 shares.
Is this portfolio well diversified?
b. Another portfolio also is invested in the same n shares, where n is
very large. Instead of equally weighting with portfolio weights of
1/n in each stock, the weights in half the securities are 1.5/n while
the weights in the other shares are .5/n. Is this portfolio well
diversified?

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Excess Returns as a Function of
the Systematic Factor

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The Security Market Line (SML) of the APT
• All well-diversified portfolio with the same beta must have the same
expected return
• Risk premiums must be proportional to betas.
• A security market line relates the portfolio risk premium to its beta
against a market index rather than an unspecified macro factor.
SML

14
The SML of the APT
• Therefore, we can write the excess return on a well-diversified
portfolio P as
𝑅𝑃 = 𝛼𝑃 + 𝛽𝑃 𝑅𝑀
• Generally, for any well-diversified P, the expected excess return
must be:
E ( RP ) =  P E ( RM )
• Risk premium on portfolio P is the product of its beta and the risk
premium of the market index
• SML of the CAPM must also apply to well-diversified portfolios simply by
virtue of the “no-arbitrage” requirement of the APT.
P
CAPM SML APT 15
Returns as a Function of the Systematic
Factor: An Arbitrage Opportunity

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An Arbitrage Opportunity

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APT and CAPM

APT CAPM
• Built on the foundation of well- • Model is based on an inherently
diversified portfolios unobservable “market” portfolio
• Cannot rule out a violation of the
expected return-beta relationship for • Provides unequivocal statement on
any particular asset the expected return-beta
• Does not assume investors are relationship for all securities
mean-variance optimizers
• Uses an observable market index

18
A Multifactor APT
• There are several sources of systematic risk and exposure to these
factors will affect a stock’s appropriate expected return
• APT can be generalized to accommodate these multiple sources of
risk
• Assume a two-factor model:

Ri = E ( Ri ) + i1 F1 + i 2 F2 + ei

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A Multifactor APT
• Benchmark portfolios in the APT are factor portfolios
• Well-diversified portfolios to have β=1 for one of the factors and β= 0 for any
other factors
• Factor portfolios track a particular source of macroeconomic risk, but are
uncorrelated with other sources of risk
• Referred to as a “tracking portfolio”
• The multifactor SML predicts that the contribution of each source of
risk to the security’s total risk premium equals the factor beta times
the risk premium of the factor portfolio tracking that source of risk.
𝐸 𝑟𝑃 = 𝑟𝑓 + 𝛽𝑃1 [𝐸 𝑟1 − 𝑟𝑓 ] + 𝛽𝑃2 [𝐸 𝑟2 − 𝑟𝑓 ]

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Example: Multifactor SML
• Suppose that the two factor portfolios, portfolios 1 and 2, have
expected returns 𝐸 𝑟1 = 10% and 𝐸 𝑟2 = 12% and that the risk-
free rate is 4%. Now consider a well-diversified portfolio, portfolio P,
with beta on the first factor portfolio, 𝛽𝑃1 = .5, and beta on the
second factor portfolio, 𝛽𝑃1 = .75.

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 Fama-French (FF) Three-Factor Model
• FF is an approach to identify the most likely sources of systematic risk, in
which case it uses firm characteristics that seem on empirical grounds to
proxy for exposure to systematic risk.

Rit = i + iM RMt + iSMB SMBt + iHML HMLt + eit

• SMB = Small minus big (i.e., the return of a portfolio of small

stocks in excess of the return on a portfolio of large stocks)
• HML = High minus low (i..e, the return of a portfolio of stocks with
a high book-to- market ratio in excess of the return on a
portfolio of stocks with a low book-to-market ratio)
22
Estimating and Implementing a Three-Factor SML
• Begin by estimating Amazon’s beta on each of the FF factors
𝑟𝐴𝑚𝑎𝑧𝑜𝑛,𝑡 − 𝑟𝑓,𝑡 = 𝛼𝐴𝑚𝑎𝑧𝑜𝑛 + 𝛽𝑀 𝑟𝑀,𝑡 − 𝑟𝑓,𝑡 + 𝛽𝐻𝑀𝐿 𝑟𝐻𝑀𝐿,𝑡 + 𝛽𝑆𝑀𝐵 𝑟𝑆𝑀𝐵,𝑡 + 𝑒𝐴𝑚𝑎𝑧𝑜𝑛,𝑡

23
The Efficient Market Hypothesis: Overview
(Textbook Chapter 11)
• Maurice Kendall (1953) found no predictable pattern in stock price
changes
• Prices were as likely to go up as to go down on any particular day, regardless
of past performance
• How do we explain random stock price changes?

24
 EMH
EMH

Random Walks and Efficient Markets

• Efficient market hypothesis (EMH)
• Prices of securities fully reflect available information
• Investors buying securities in an efficient market should expect to obtain an
equilibrium rate of return
• Stock prices should follow a random walk
• Stock price changes are random and unpredictable
• Necessary consequence of intelligent investors competing to discover
relevant information on which to buy or sell stocks before the rest of the
market becomes aware of that information

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Cumulative Abnormal Returns Before
Takeover Attempts

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Stock Price Reaction to CNBC Reports

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Competition as the Source of Efficiency
• Information:
• The most precious financial commodity
• Strong competition assures prices reflect information
• Higher investment returns motivates information-gathering
• The incremental rates of return on research activity may be so small that only
managers of the largest portfolios will find it useful pursuing

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Versions of the EMH
1. Weak-form asserts that stock prices already reflect all information
contained in the history of past prices
2. Semistrong-form asserts that stock prices already reflect all publicly
available information
3. Strong-form asserts that stock prices reflect all relevant
information, including insider information

• All versions assert that prices should reflect available information

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Self-Check Exercise
1. Suppose you observed that high-level managers make superior
returns on investments in their company’s stock. Would this be a
violation of weak-form market efficiency? Would it be a violation of
strong-form market efficiency?
2. If the weak-form version of the efficient market hypothesis is valid,
must the strong-form version also hold? Conversely, does strong-
form efficiency imply weak-form efficiency?

30
Information Sets of Three Forms of EMH

31
Technical Analysis
• Technical analysis - Research to identify mispriced securities that
focuses on recurrent and predictable stock price patterns and on
proxies for buy or sell pressure in the market
• Key to success is a sluggish response of stock prices to fundamental supply-
and-demand factors
• EMH implies technical analysis should be fruitless

32
Fundamental Analysis
• Fundamental analysis
• Assessment of firm value that focuses on such determinants as earnings and
dividends prospects, expectations for future interest rates, and risk evaluation
• Seeks to find firms that are mispriced
• Attempt to find firms that are better than everyone else’s estimate or troubled firms that
may be great bargains
• EMH predicts that most fundamental analysis is doomed to failure

33
Active versus Passive Portfolio Management
• Active Management
• An expensive strategy
• Suitable for very large portfolios
• Passive Management
• No attempt to outsmart the market
• Accept EMH
• Index Funds and ETFs
• Low cost strategy

34
Portfolio Management in an Efficient Market
• Even if the market is efficient, a role exists for portfolio management:
• Diversification
• Risk profile of investor
• E.g., investors of different ages, risk aversion, and employment

35
Event Studies
• An event study is a methodological approach designed to measure
the impact of an event of interest on stock returns

• The abnormal return due to the event is the difference between the
stock’s actual return and a proxy for the stock’s return in the absence
of the event

36
How Tests Are Structured
• Returns are adjusted to determine if they are abnormal
• Market model approach:
a. Expected Return:
𝑟𝑡 = 𝑎 + 𝑏𝑟𝑀𝑡 + 𝑒𝑡
b. Abnormal Return:
𝑒𝑡 = 𝑟𝑡 − (𝑎 + 𝑏𝑟𝑀𝑡 )

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Example: Abnormal Returns
• Suppose that the analyst has estimated that a = .05% and b = .8. On a
day that the market goes up by 1%, you would predict that the stock
should rise by an expected value of __________________________.
If the stock actually rises by 2%, the analyst would infer that firm-
specific news that day caused an additional stock return of
______________________, which is the abnormal return for the day.

38
Are Markets Efficient?
• Magnitude issue
• Only managers of large portfolios can earn enough trading profits to make the
exploitation of minor mispricing worth the effort
• Selection bias issue
• Only unsuccessful (or partially successful) investment schemes are made
public; good schemes remain private
• Lucky event issue
• For every big winner, there may be
many big losers, but we never hear
of these managers

39
Weak-Form Tests
• One way of discerning trends in stock prices is by measuring the serial
correlation of stock market returns.
• Returns over short horizons
• Tendency of poorly performing stocks and well-performing stocks in one period
to continue that abnormal performance in following periods is the momentum
effect
• Returns over long horizons
• Reversal effect is the tendency of poorly performing stocks and well-performing
stocks in one period to experience reversals in following periods

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 Semistrong Tests: Small-Firm Effect
• The small-firm effect
was originally
documented by
Banz (1981), and
suggests
investments in
stocks of small firms
appear to have
abnormal returns.

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Semistrong Tests: Book to Market Effects

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Semistrong Tests: Post-Earnings-Announcement
Price Drift
• Price Drift
• Ball and Brown (1968) find a sluggish
response of stock prices to firms’
earnings announcements
• Market appears to adjust to the
earnings information only gradually,
resulting in a sustained period of
abnormal returns
• One could have earned abnormal
profits simply by waiting for earnings
announcements and purchasing a
stock portfolio of positive-earnings-
surprise companies, which ought to
be impossible in an efficient market.
43
Semistrong Tests: Other Anomalies
• Efficient market anomalies are patterns of returns that seem to
contradict the EMH
• P/E effect – Basu (1977, 1983) discovered that portfolios of low-P/E ratio
stocks have provided higher returns than high P/E portfolios
• Neglected-firm effect – investments in stock of less well-known firm have
generated abnormal returns
• Liquidity effect – Illiquid stocks have a strong tendency to exhibit abnormally
high returns

44
Strong-Form Tests: Inside Information
• It would not be surprising if insiders were able to make superior
profits trading in their firm’s stock
• In other words, we do not expect markets to be strong-form efficient;
we regulate and limit trades based on inside information.
• Can other investors benefit by following insiders’ trades?
• Insiders are required to register their trading activity, and these trades
become public.
• If markets are efficient, fully and immediately processing that information, an
investor should not be able to profit from following those trades.

45
So, Are Markets Efficient?
• Enough anomalies exist in the empirical evidence to justify the search
for underpriced securities that clearly takes place
• However, the market is competitive enough that only differentially superior
information or insight will earn money
• Margin of superiority that any professional manager can add is so slight that
the statistician will not easily be able to detect it
• We conclude that markets are generally very efficient, but that
rewards to the especially diligent, intelligent, or creative may in fact
be waiting

46
Summary
• APT relies on three key propositions
1. Security returns can be described by a factor model
2. There are sufficient securities to diversify away idiosyncratic risk
3. Well-functioning security markets do not allow for the persistence of
arbitrage opportunities
• Single factor model
𝑅𝑖 = 𝐸 𝑅𝑖 + β𝑖 𝐹 + 𝑒𝑖
• Variance can be separated into systematic and firm-specific risks

𝜎𝑃2 = 𝛽𝑃2 𝜎𝐹2 + 𝜎 2 𝑒𝑃 = 𝛽𝑃2 𝜎𝐹2 + ෍ 𝑤𝑖2 𝜎 2 𝑒𝑖

47
Summary
• Multifactor model
𝑅𝑖 = 𝐸 𝑅𝑖 + β𝑖1 𝐹1 + β𝑖2 𝐹2 + 𝑒𝑖
• Multifactor SML
𝐸 𝑟𝑃 = 𝑟𝑓 + 𝛽𝑃1 [𝐸 𝑟1 − 𝑟𝑓 ] + 𝛽𝑃2 [𝐸 𝑟2 − 𝑟𝑓 ]

• Well-diversified portfolios
• Firm-specific risk becomes negligible, so that only factor risk remains.
• A well-diversified portfolio is one with each weight small enough that for
practical purposes the nonsystematic variance is negligible

48
Summary

APT CAPM
• Built on the foundation of well- • Model is based on an inherently
diversified portfolios unobservable “market” portfolio
• Cannot rule out a violation of the
expected return-beta relationship for • Provides unequivocal statement on
any particular asset the expected return-beta
• Does not assume investors are relationship for all securities
mean-variance optimizers
• Uses an observable market index

49
Summary
• State whether the following arguments are correct or not.
a. Both the CAPM and APT require a mean-variance efficient market portfolio.
b. Neither the CAPM nor the APT assumes normally distributed security
returns.
c. The CAPM assumes that one specific factor explains security returns but
APT does not.
• According to the theory of arbitrage:
a. High-beta stocks are consistently overpriced.
b. Low-beta stocks are consistently overpriced.
c. Positive alpha investment opportunities will quickly disappear.
d. Rational investors will pursue arbitrage opportunities consistent with their
risk tolerance.

50
Summary
• Consider a single factor APT. Portfolio A has a beta of 2.0 and an expected return
of 22%. Portfolio B has a beta of 1.5 and an expected return of 17%. The risk-free
rate of return is 4%. If you wanted to take advantage of an arbitrage opportunity,
you should take a short position in portfolio __________ and a long position in
portfolio _______.

A) A; A
B) A; B
C) B; A
D) B; B
E) A; the riskless asset

51
Summary
• Efficient markets hypothesis (EMH)
• Prices of securities fully reflect available information
• Investors buying securities in an efficient market should expect to obtain an
equilibrium rate of return
• Three versions of EMH: weak-form, semistrong-form, strong-form

52
Summary
• Tests about market efficiency
• Weak-form: serial correlation of stock market returns
• Semistrong: small-firm effect, book to market effects, post-earnings-
announcement price drift; efficient market anomalies
• Strong: insider information
• Which of the following would be a viable way to earn abnormally high
trading profits if markets are semistrong-form efficient?
a. Buy shares in companies with low P/E ratios.
b. Buy shares in companies with recent above-average price changes.
c. Buy shares in companies with recent below-average price changes.
d. Buy shares in companies for which you have advance knowledge of an
improvement in the management team.
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Summary
• You know that firm XYZ is very poorly run. On a scale of 1 (worst) to
10 (best), you would give it a score of 3. The market consensus
evaluation is that the management score is only 2. Should you buy or
sell the stock?
• The monthly rate of return on T-bills is 1%. The market went up this
month by 1.5%. In addition, AmbChaser, Inc., which has an equity
beta of 2, surprisingly just won a lawsuit that awards it $1 million
immediately.
a. If the original value of AmbChaser equity were $100 million, what would
you guess was the rate of return of its stock this month?
b. What is your answer to (a) if the market had expected AmbChaser to win $2
million?

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