Corporate Finance

Tutorial 5 Suggested Solutions

Corporate Finance
Tutorial 5: Arbitrage Pricing Theory (APT)
Suggest Solutions
Exercises on Arbitrage Pricing Theory
A1.

rA = 0.10 + F1 ! 0.5 F2
rB = 0.08 + 2 F1 ! F2
rC = 0.05 + 0.5 F1 ! 0.5 F2
First factor-replicating portfolio (FR1)
WA + WB + WC
WA + 2WB + 0.5 WC
0.5 WA WB 0.5 WC

! FR1

=1
=1
=0

WA
WB
WC

= 4
= 1
= 2

WA
WB
WC

= 8
= 3
= 4

= W A! A + WB! B + WC! C

= 4(0.10) + (1)(0.08) + (2)(0.05)

= 0.40 0.08 0.10
= 0.22

! 1, FR1 = W A ! 1, A + WB ! 1, B + WC ! 1,C
= (4)(1) + (1)(2) + (2)(0.5)
=421
=1

! 2, FR1 = W A ! 2, A + WB ! 2, B + WC ! 2,C
= (4)(0.5) + (1)(1) + (2)(0.5)
= 2 + 1 + 1
=0

rFR1

= 0.22 + F1

E(rFR1 ) = 0.22

Second factor-replicating portfolio (FR2)

WA + WB + WC
WA + 2WB + 0.5 WC
0.5 WA WB 0.5 WC

" FR 2

=1
=0
=1

= 8(0.10) + (!3)(0.08) + (!4)(0.05)

= 0.80 0.24 0.20
= 0.36

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" 1, FR 2 = 8(1) + (!3)(2) + (!4)(0.5)

=862
=0

" 2, FR 2 = 8(!0.5) + (!3)(!1) + (!4)(!0.5)

= 4 + 3 + 2
=1

rFR2

= 0.36 + F2

E(rFR2 ) = 0.36

Risk-free replicating portfolio (FRP)

WA + WB + WC
WA + 2WB + 0.5 WC
0.5 WA WB 0.5 WC

" FRP

=1
=0
=0

WA
WB
WC

= 2
= 1
= 0

= (2)(0.10) + (!1)(0.08) + (0)(0.05)

= 0.20 0.08
= 0.12

" 1, FRP = (2)(1) + (!1)(2) + (0)(!0.5)

=22+0
=0

" 2, FRP = (2)(!0.5) + (!1)(!1) + (0)(!0.5)

= 1 + 1 + 0
=0

rFRP

= 0.12

E(rFRP ) = 0.12

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A2.

Tutorial 5 Suggested Solutions

E (r1 ) = 22%
"1 = 22% #12% = 10%
E (r2 ) = 36%
rf = 12%
"2 = 36% #12% = 24%
!
Hence, the expected return on any asset can be written as follows:
!
E(ri ) = 12% + 10%"1i + 24%"2i

To check:

E (rA) = 0.12 + 0.10 (1) + 0.24 (0.5)

= 0.12 + 0.10 0.12
= 0.10
E (rB) = 0.12 + 0.10 (2) + 0.24 (-1)
= 0.12 + 0.20 0.24
= 0.08
E(rC) = 0.12 + 0.10 (0.5) + (0.24)(0.5)
= 0.12 + 0.05 0.12
= 0.05
A3.

rD

= 0.15 + 3F1 F2

To construct a factor-replicating portfolio (FRD) as portfolio D:

WA + WB + WC
WA + 2WB + 0.5 WC
0.5WA WB 0.5WC

= 1
= 3
= 1

WA
WB
WC

= 2
= 1
= 2

" FRD = 2(0.10) + (1)(0.08) + (#2)(0.05)

= 0.20 + 0.08 - 0.10
= 0.18
$1, FRD = (2)(1) + (1)(2) + (#2)(#0.5)

$2, FRD

= 2 + 2 -1
= 3
= (2)(#0.5) + (1)(#1) + (#2)(#0.5)
= #1#1+ 1
= -1

rFRD = 0.18 + 3F1 " F2

!

=>

Arbitrage opportunity exists

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Tutorial 5 Suggested Solutions

Suggested Solution to FE2008 Zone B Question A2

(a)

Regression model :
R A = 0.04 + 0.2 Rm + A
RB = 0.01 + 0.8 Rm + B

To find AB , AM, BM

AB = Cov (A + ARm + A, B + BRm + B)

= Cov (ARm + A, BRm + B)
= Cov (ARm, + BRm) + Cov (ARm, B) + Cov (BRm, A) + Cov (A,
= A B2m + A Cov (Rm, B) + B Cov (Rm, A) + Cov (A, B)
= A B2m = (0.2)(0.8) (0.252) = 0.0403

B)

AM = Cov ( + ARm + A, Rm)

= Cov (ARm + A, Rm)
= Cov (ARm, Rm) + Cov (A, Rm)
= A2m = (0.2) (0.252) = 0.0504

BM = B2m = (0.8) (0.252) = 0.2016

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(b)

Tutorial 5 Suggested Solutions

Using regression model

=> ER (A) = 0.04 + 0.2 (0.12) = 0.064
ER (B) = 0.01 + 0.8 (0.12) = 0.1060
Using CAPM
ER (i) = Rf + i [Rm Rf]
ER(A) = 0.05 + (0.2) (0.7) = 0.064
ER(B) = 0.05 + (0.8) (0.7) = 0.1060

Hence, these portfolios satisfy CAPM equation. A good fix however does
not necessarily mean support for CAPM model due to Joint Hypothesis
problem.
(c)

Given
RA = 0.064 + 0 F1 + 0.5 F2 + A
RB = 0.106 + 1 F1 + 0.8 F2 + B
Rf = 0.05 ; To find 1 & 2
ER(i) = Rf + 1i 1 + 2i 2
ER(A) = 0.064
=> 0.064 = 0.05 + (0) 1 + (0.5) 2
0.5 2 = 0.064 0.05 = 0.014
2 = 0.014 = 0.028 = 2.8%
0.5
ER(R) = 0.106
=> 0.106 = 0.05 + (1) 1 + (0.8) 2
=>

1 = 0.106 0.05 (0.8) (0.028)

= 0.0336 = 3.36%

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Suggested Solution to FE2010 A4(b)

Whether it is a one-factor model, such as CAPM, or a multi-factor model, such as
APT, both can be used to price asset in equilibrium. The former uses market index
as the only factor that determines the expected rate of return of risky asset. How
sensitive is the expected return of an asset is to that of the market is measured by
beta coefficient (). Hence,



ER(i) = rf + (Rm - rf )



The CAPM starts by dividing risk into two major components: diversifiable risk and
non-diversifiable risk. While risk can be diversified away by forming portfolio, the
premise is that there is a close relationship between the returns of individual
securities and the returns of the market, or non-diversifiable risk. The above
equation shows that the CAPM model starts with a risk-free rate, and then adds a
premium consisting of the market returns plus an adjustment called beta. The
graphical presentation of CAPM is known as SML. SML thus shows the expected
return on a security is a positive linear function of the securitys sensitivity to
changes in the market portfolios return. The CAPM and SML approaches, however,
are not free of problems. There may be other, more important factors besides the
market that influence the returns of a security. Some researchers, such as Roll,
pointed out that the stock market indexes, like the S&P 500 Composite Index, are
merely proxies and do not represent the true market index. Others say that the
calculation of CAPM values is based on past historical data, while the model is for
calculation of expected values. Consequently, historical betas cannot serve as a basis
for establishing the true expected rate of return for a security. Some studies also
indicated that other measures, such as size and the ratio of book value to price, are
more suitable indicators of stock returns.

APT model, on the other hand, states that the expected returns of securities are
influenced by a number of industry and financially related factors. This model
claims to give a broader explanation of the relationship between risks and returns,
hence its usage are less restrictive. Each stock reacts differently to a projected
factors event and its sensitivity to that factor is captured in the beta coefficients
assigned to each factor. Beta, therefore, measures the responsiveness of a stocks
returns to a factor. The relationship between expected returns and a factor can be
either positive or negative. The market portfolio that plays such a central role in the
CAPM does not necessarily feature in APT, so one does not have to worry about the
problems of measuring the market portfolio. Many of the empirical studies that
cannot be satisfactory explained by CAPM (e.g. small firm effect) are well placed
under APT (which explains small firm is sensitive to more than just the return on
market portfolio).

APT considers a number of factors while CAPM takes into account only one factor, a
market index. When the only factor in the APT model is the market index, both

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models are very similar. However, it would seem logical to assume that a
multifactor model produces more realistic results.

The APT model, however, runs into several problems. It not only involves highly
complex mathematical formulations requiring enormous calculations, but the
results of APT change as sample size, from which the factors are selected, increases.
There are also positive or negative sign problems to deal with. Furthermore, APT
does not identify what the underlying factors are unlike CAPM which collapses all
macroeconomic risks into a well-defined single factor, the return on market
portfolio.

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