Chapter 10: Arbitrage Pricing Theory and Multifactor Models of Risk and Return

I. Multifactor Models: An Overview a. Factor models are tools that allow us to describe and quantify the different factors that affect the rate of return on a security during any time period. b. Factor Models of Security Returns i. Single-factor model: a model of security returns that acknowledges only one common factor. ( ) 1. ii. Multifactor models: model of security returns positing that returns respond to several systematic factors. iii. Factor sensitivities, factor loadings, factor betas: coefficients that measure the sensitivity of share returns to a specific factor. 1. Interest rate betas would be expected to be negative. c. Multifactor Security Market Line i. CAPM asserts that securities will be priced to give investors an expected return comprised of two components: 1. The risk-free rate 2. Risk premium ii. Multifactor model gives a much better way to think about risk exposures and compensation for those exposures than the single-index model or CAPM. Arbitrage Pricing Theory: an asset pricing theory that is derived from a factor model, using diversification and arbitrage arguments. The theory describes the relationship between expected returns on securities, given that there are no opportunities to create wealth through risk-free arbitrage investments. a. Relies on: i. Security returns can be described by a factor model. ii. There are sufficient securities to diversify away idiosyncratic risk. iii. Well-functioning security markets do not allow for the persistence of arbitrage opportunities. b. Arbitrage: a zero-risk, zero-net investment strategy that still generates profits. i. Risk-free arbitrage portfolio any investor, regardless of risk aversion or wealth, will want to take an infinite position on it. c. Law of One Price: if two assets are equivalent in all economically relevant aspects, then they should have the same price. i. Market prices will move to rule out arbitrage opportunities.

II.

III.

IV.

V.

d. CAPM dominance argument all investors hold mean-variance efficient portfolios. e. Risk Arbitrage: speculation on perceived mispriced securities, usually in connection with merger and acquisition targets. f. Well-diversified portfolio: one that is diversified over a large enough number of securities, with each weight, wi, small enough that for practical purposes the nonsystematic variance is negligible. g. Betas and Expected Returns i. Nonsystematic risk across firms cancels out in well-diversified portfolios. Individual Assets and the APT a. APT and the CAPM i. APT 1. Gives a benchmark for rates of return that can be used in capital budgeting, security valuation, or investment performance evaluation. 2. Highlights the crucial distinction between non-diversifiable risk that requires a reward in the form of a risk premium and diversifiable risk that does not. 3. Focuses on no-arbitrage condition a. Without the further assumptions of the market or index model, the APT cannot rule out a violation of the expected return-beta relationship for any particular asset. ii. CAPM 1. Derived assuming an inherently unobservable market portfolio. 2. Rests on mean-variance efficiency A Multifactor APT a. Factor portfolio: a well-diversified portfolio constructed to have a beta of 1 on one of the factors and a beta of zero on any other factor. i. Sever as the benchmark portfolios for a multifactor security market line. Where Should We Look For Factors? a. Fama-French Three Factor Model i.

ii. Problems:

VI.

1. None of the factors in the proposed models can be clearly identified as hedging a significant source of uncertainty. Multifactor CAPM and the APT a. CAPM i. Factors are derived from a multiperiod consideration of a stream of consumption as well as randomly evolving investment opportunities pertaining to the distributions of rates of return. ii. Inherit its risk factors from sources of risk that a broad group of investors deem important enough to hedge. b. APT i. Silent on where to look for priced sources of risk.