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Chapter 10

Chapter 10 discusses Arbitrage Pricing Theory (APT) and multifactor models of risk and return, emphasizing the expected return on securities as a function of risk-free rates and sensitivities to various risk factors. It highlights the importance of diversification in eliminating idiosyncratic risk and the rapid disappearance of arbitrage opportunities in efficient markets. The chapter also introduces the Fama-French three-factor model and the relationship between multifactor CAPM and APT.

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Hamza Habib
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11 views19 pages

Chapter 10

Chapter 10 discusses Arbitrage Pricing Theory (APT) and multifactor models of risk and return, emphasizing the expected return on securities as a function of risk-free rates and sensitivities to various risk factors. It highlights the importance of diversification in eliminating idiosyncratic risk and the rapid disappearance of arbitrage opportunities in efficient markets. The chapter also introduces the Fama-French three-factor model and the relationship between multifactor CAPM and APT.

Uploaded by

Hamza Habib
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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CHAPTER 10

Arbitrage Pricing
Theory and
Multifactor Models of
Risk and Return
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Multifactor SML Models

𝐸[𝑟𝑖 ] = 𝑟𝑓 +

𝛽𝑖,𝐺𝐷𝑃 𝑅𝑃𝐺𝐷𝑃 +
𝛽𝑖,𝐺𝐷
𝛽 𝑅𝑃
= Factor sensitivity for
𝑅𝑃 𝑖,𝐼𝑅 GDP𝐼𝑅
𝑃 𝑖,𝐺𝐷𝑃= Risk premium for

𝛽𝑖,𝐼𝑅
GDP = Factor sensitivity for Interest
Rate
𝑅𝑃𝑖, = Risk premium for Interest
𝐼𝑅 Rate
INVESTMENTS | BODIE, KANE, MARCUS
Interpretation
The expected return on a security is
the sum of:
1.The risk-free rate
2.The sensitivity to GDP times
the risk premium for bearing
GDP risk
3.The sensitivity to interest rate risk
times the risk premium for
bearing interest rate risk

INVESTMENTS | BODIE, KANE, MARCUS


Arbitrage Pricing Theory
1. Securities described with a Factor
Model
2. There are enough securities to
diversify away idiosyncratic risk
3. Arbitrage will disappear quickly

• Arbitrage when a zero investment


portfolio has a sure profit
• No investment is required so
investors can create large positions
to obtain large profits
INVESTMENTS | BODIE, KANE, MARCUS
Arbitrage Pricing
Theory
• Regardless of • In efficient
wealth or risk markets,
aversion, investors profitable
will want an arbitrage
infinitely large opportunities will
position in the quickly
risk-free disappear.
arbitrage
portfolio.

INVESTMENTS | BODIE, KANE, MARCUS


APT & Well-Diversified

𝑅𝑃 = 𝐸[𝑅𝑃] + 𝛽𝑃 𝐹 + 𝑒𝑃
Portfolios

F = some factor

• For a well-diversified portfolio, 𝑒𝑃:


– approaches zero as the number of
securities in the portfolio increases
– and their associated weights decrease

INVESTMENTS | BODIE, KANE, MARCUS


APT Model

𝐸 𝑅𝑃= 𝛽𝑃 𝐸 𝑅𝑀
• APT applies to well diversified
portfolios and not necessarily to

• It implies 𝛼 = 0
individual stocks.

• With APT it is possible for some


individual stocks to be mispriced – not
lie on the SML, although APT must
hold for most stocks (proof is difficult but
reasoning can be illustrated)
• APT can be extended to multifactor
INVESTMENTS | BODIE, KANE, MARCUS
Multifactor APT
• Use of more than a single systematic
factor
• Requires formation of factor portfolios
• What factors to choose?
– Factors that are important to performance
of the general economy
– What about firm characteristics?

– (example)

INVESTMENTS | BODIE, KANE, MARCUS


Two-Factor Model

𝑅𝑖 = 𝐸[𝑅𝑖] + 𝛽𝑖,1𝑅𝑖 +
𝛽𝑖,2 𝐹2 + 𝑒𝑖

• The multifactor APT is similar to the


one- factor case.
• Each factor F has zero expected value
as it measures the surprise, not the
level.
• Also ei has zero expected value.

INVESTMENTS | BODIE, KANE, MARCUS


Two (or multi)-Factor
Model
• Track with diversified factor
portfolios
• The factor portfolios track a
particular source of
macroeconomic risk, but are
uncorrelated with other sources

• Each factor portfolio has 𝛽=1 for one


of risk

of the factors and 0 for all other


factors (important)

INVESTMENTS | BODIE, KANE, MARCUS


Where Should We Look for
Factors?
• Need important systematic risk
factors
– Chen, Roll, and Ross used industrial
production, expected inflation,
unanticipated inflation, excess return
on corporate bonds, and excess return
on government bonds.
– Fama and French used firm
characteristics that proxy for
systematic risk factors.
INVESTMENTS | BODIE, KANE, MARCUS
Fama-French Three-Factor
Model
• SMB = Small Minus Big (return of small in
excess of big firms, based on firm size)
• HML = High Minus Low (return of firms
with high Book-to-Market ratio, over those
with low BtM)
• Are these firm characteristics correlated with
actual (but currently unknown) systematic
risk factors?

𝑅𝑖,𝑡 = 𝛼𝑖 + 𝛽𝑖,𝑀𝑅𝑀𝑡

+𝛽𝑖,𝑆𝑀𝐵𝑆𝑀𝐵𝑡
INVESTMENTS | BODIE, KANE, MARCUS
The Multifactor CAPM and the
APT
• A multi-index CAPM will inherit its
risk factors from sources of risk
that a broad group of investors
deem important enough to hedge
• The APT is largely silent on
where to look for priced sources
of risk

INVESTMENTS | BODIE, KANE, MARCUS


Chapter 10
Problems

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