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Tutorial 8


Faculty of Business and Economics
FINA2802_FINA2320_D – Investments and Portfolio Analysis
1st SEMESTER, 2017-2018

Chapter 10 Arbitrage Pricing Theory and Multifactor Models of Risk

and Return

 10.1 Multifactor Models: An Overview

 Factor Models of Security Returns:
ri = E(ri ) + βi1 F1 + βi2 F2 + ⋯ + βiK FK + ei

 A Multifactor Security Market Line:

E(ri ) = rf + βi1 RP1 + βi2 RP2 + ⋯ + βiK RPK

 10.2 Arbitrage Pricing Theory

 Assumptions:
 Security returns can be described by a factor model.
 There are sufficient to diversify away unsystematic risk.
 Well-functioning security markets do not allow for the persistence of arbitrage

 Arbitrage, Risk Arbitrage, and Equilibrium

 An arbitrage opportunity arises when an investor can earn riskless profits without
making a net investment.
 The Law of One Price states that if two assets are equivalent in all economically
relevant respects, then they should have the same market price. The Law of One
Price is enforced by arbitrageurs: if they observe a violation of the law, they will
engage in arbitrage activity—simultaneously buying the asset where it is cheap
and selling where it is expensive. In the process, they will bid up the price where
it is low and force it down where it is high until the arbitrage opportunity is
 The critical property of a risk-free arbitrage portfolio is that any investor,
regardless of risk aversion or wealth, will want to take an infinite position in it.
Because those large positions will quickly force prices up or down until the
opportunity vanishes, security prices should satisfy a “no-arbitrage condition,”
that is, a condition that rules out the existence of arbitrage opportunities.
 When arbitrage opportunities exist, each investor wants to take as large a position
as possible; hence it will not take many investors to bring about the price
pressures necessary to restore equilibrium.

 Well-diversified Portfolios
rp = E(rp ) + βp Fp
 ep = 0

Tutorial 8
Tutorial 8

 10.3 Individual Assets and the APT

 APT:
 It is possible for some individual assets not to lie on the SML.
 Can be derived without using the market portfolio.
 Equilibrium means no arbitrage opportunities.
 APT equilibrium is quickly restored even if only a few investors recognize an
arbitrage opportunity.
 Can be extended to multifactor models.

 It describes equilibrium for all assets.
 Model is based on an inherently unobservable market portfolio.
 Rests on mean-variance efficiency.
 The actions of many small investors restore CAPM equilibrium.
 Cannot add more factors to the model.

 10.4 A Multifactor APT

 The APT equilibrium rate of return:
𝐄(𝐫𝐢 ) = 𝐫𝐟 + 𝛃𝐢𝟏 𝐑𝐏𝟏 + 𝛃𝐢𝟐 𝐑𝐏𝟐 + ⋯ + 𝛃𝐢𝐊 𝐑𝐏𝐊

 10.5 Where Should We Look for Factors?

Tutorial 8
Tutorial 8

Jeffrey Bruner, CFA, uses the capital asset pricing model (CAPM) to help identify
securities. A consultant suggests Bruner use arbitrage pricing theory (APT) instead. In
comparing CAPM and APT, the consultant made the following arguments (State whether
each of the consultant’s arguments is correct or incorrect. Indicate, for each incorrect
argument, why the argument is incorrect.):
a. Both the CAPM and APT require a mean-variance efficient market portfolio.
This statement is incorrect. The CAPM requires a mean-variance efficient market
portfolio, but APT does not.
b. The CAPM assumes that one specific factor explains security returns but APT does not.
This statement is correct.

A zero-investment portfolio with a positive alpha could arise if:
a. The expected return of the portfolio equals zero.
b. The capital market line is tangent to the opportunity set.
c. The Law of One Price remains unviolated.
d. A risk-free arbitrage opportunity exists.

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 consistent with their risk tolerance.

The arbitrage pricing theory (APT) differs from the single-factor capital asset pricing model
(CAPM) because the APT:
a. Places more emphasis on market risk.
b. Minimizes the importance of diversification.
c. Recognizes multiple unsystematic risk factors.
d. Recognizes multiple systematic risk factors.

An investor takes as large a position as possible when an equilibrium price relationship is
violated. This is an example of:
a. A dominance argument.
b. The mean-variance efficient frontier.
c. Arbitrage activity.
d. The capital asset pricing model.

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Tutorial 8

The feature of arbitrage pricing theory (APT) that offers the greatest potential advantage
over the simple CAPM is the:
a. Identification of anticipated changes in production, inflation, and term structure of
rates as key factors explaining the risk–return relationship.
b. Superior measurement of the risk-free rate of return over historical time periods.
c. Variability of coefficients of sensitivity to the APT factors for a given asset over time.
d. Use of several factors instead of a single market index to explain the risk–return

In contrast to the capital asset pricing model, arbitrage pricing theory:
a. Requires that markets be in equilibrium.
b. Uses risk premiums based on micro variables.
c. Specifies the number and identifies specific factors that determine expected returns.
d. Does not require the restrictive assumptions concerning the market portfolio.

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Tutorial 8

Suppose that two factors have been identified for the U.S. economy: the growth rate of
industrial production, IP, and the inflation rate, IR. IP is expected to be 3%, and IR 5%. A
stock with a beta of 1 on IP and 0.5 on IR currently is expected to provide a rate of return of
12%. If industrial production actually grows by 5%, while the inflation rate turns out to be
8%, what is your revised estimate of the expected rate of return on the stock?
ri = E(ri ) + βi1 F1 + βi2 F2 + ⋯ + βiK FK + ei
= 12% + 1(5% − 3%) + 0.5(8% − 5%)
= 𝟏𝟓. 𝟓%

Suppose that there are two independent economic factors, F1 and F2. The risk-free rate is
6%, and all stocks have independent firm-specific components with a standard deviation of
45%. The following are well-diversified portfolios:

What is the expected return–beta relationship in this economy?

E(rp ) = rf + βP1 [E(r1 )  rf ] + βP2 [E(r2 ) – rf ]

RP1 = [E(r1 )  rf ] and RP2 = [E(r2 )  rf ]

0.31 = 0.06 + (1.5 × RP1 ) + (2.0 × RP2 )

0.27 = 0.06 + (2.2 × RP1 ) + [(–0.2) × RP2 ]

RP1 = 10% and RP2 = 5%

E(rP ) = 6% + (βP1 × 10%) + (βP2 × 5%)

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Tutorial 8

Consider the following data for a one-factor economy. All portfolios are well diversified.

Suppose that another portfolio, portfolio E, is well diversified with a beta of 0.6 and
expected return of 8%. Would an arbitrage opportunity exist? If so, what would be the
arbitrage strategy?

For Portfolio A, the ratio of risk premium to beta is: (12 − 6)/1.2 = 5
For Portfolio E, the ratio is lower at: (8 – 6)/0.6 = 3.33

This implies that an arbitrage opportunity exists. For instance, you can create a Portfolio G
with beta equal to 0.6 (the same as E’s) by combining Portfolio A and Portfolio F in equal
weights. The expected return and beta for Portfolio G are then:
E(rG ) = (0.5 × 12%) + (0.5 × 6%) = 9%
βG = (0.5 × 1.2) + (0.5 × 0%) = 0.6

Comparing Portfolio G to Portfolio E, G has the same beta and higher return. Therefore, an
arbitrage opportunity exists by buying Portfolio G and selling an equal amount of Portfolio
E. The profit for this arbitrage will be:
rG – rE =[9% + (0.6 × F)]  [8% + (0.6 × F)] = 1%
That is, 1% of the funds (long or short) in each portfolio.

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Tutorial 8

Assume that both portfolios A and B are well diversified, that E(rA) = 12%, and E(rB) = 9%.
If the economy has only one factor, and βA =1.2, whereas βB = 0.8, what must be the risk-
free rate?

12% = rf + (1.2 × RP)

9% = rf + (0.8 × RP)
rf = 3% and RP = 7.5%

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Tutorial 8

Consider the following multifactor (APT) model of security returns for a particular stock.

a. If T-bills currently offer a 6% yield, find the expected rate of return on this stock if the
market views the stock as fairly priced.
E(r) = 6% + (1.2 × 6%) + (0.5 × 8%) + (0.3 × 3%) = 18.1%

b. Suppose that the market expected the values for the three macro factors given in column
1 below, but that the actual values turn out as given in column 2. Calculate the revised
expectations for the rate of return on the stock once the “surprises” become known.

ri = 18.1% + [1.2 × (4% – 5%)] + [0.5 × (6% – 3%)] + [0.3 × (0% – 2%)]
= 17.8%

Suppose that the market can be described by the following three sources of systematic risk
with associated risk premiums.

The return on a particular stock is generated according to the following equation:

Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 6%. Is the
stock overpriced or underpriced? Explain.
E(r) = 6% + (1.0 × 6%) + (0.5 × 2%) + (0.75 × 4%) = 16%
According to the equation for the return on the stock, the actually expected return on the
stock is 15% (because the expected surprises on all factors are zero by definition). Because
the actually expected return based on risk is less than the equilibrium return, we
conclude that the stock is overpriced.

Tutorial 8
Tutorial 8

In Orb Trust, one of the analysts, McCracken, investigates the use of APT model. He
believes a two-factor APT is enough, where the factors are the sensitivity to changes in real
GDP and inflation. The factor risk premium for real GDP and inflation is 8% and 2%
respectively. He estimates for Orb’s High Growth Fund that the sensitivities to these two
factors are 1.25 and 1.50 respectively.

McCracken asks a fellow analyst, Sue Kwon, to provide an estimated of the expected
return of Orb’s Large Cap Fund based on fundamental analysis. Kwon says that the
expected return of that portfolio is 8.5% above the risk-free rate. McCracken finds that the
sensitivities to real GDP and inflation are 0.75 and 1.25 respectively.

McCracken’s manager, Jay Stiles, asks McCracken to compose a portfolio that has a unit
sensitivity to real GDP growth but is not affected by inflation. He then computes the
sensitivities for a third fund, Orb’s Utility Fund, which has sensitivities equal to 1.0 and 2.0
respectively. He will use APT results for these three funds to create a portfolio with a unit
exposure to real GDP and no exposure to inflation. That fund is called the GDP Fund.

a. According to the APT, if the risk-free rate is 4%, what should be the expected return of
Orb’s High Growth Fund?
E(rHGF ) = rf + βHGF,GDP RPGDP + βHGF,inflation RPinflation
E(rHGF ) = 4% + 1.25 × 8% + 1.5 × 2%
= 𝟏𝟕%

b. With respect to McCracken’s APT model estimate of Orb’s Large Cap Fund and the
information Kwon provides, is an arbitrage opportunity available?
E(rLCF ) = rf + βLCF,GDP RPGDP + βLCF,inflation RPinflation
E(rLCF ) = 4% + 0.75 × 8% + 1.25 × 2%
= 4% + 8.5%
= 8.5% above the risk − free rate

McCracken’s APT estimates and Kwon’s fundamental analysis estimates are

consistent, so no arbitrage opportunity.

c. What are the weights of the three funds in the GDP Fund?
1.25wHGF + 0.75wLCF + 1.0wUF = 1
1.5wHGF + 1.25wLCF + 2.0wUF = 0
wHGF + wLCF + wUF = 1

𝐰𝐇𝐆𝐅 = 𝟏. 𝟔
𝐰𝐋𝐂𝐅 = 𝟏. 𝟔
𝐰𝐔𝐅 = −𝟐. 𝟐

Tutorial 8