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(Chapter 10)
Single-Factor APT Model Multi-Factor APT Models Arbitrage Opportunities Disequilibrium in APT Is APT Testable? Consistency of APT and CAPM
the CAPM, an alternative model of asset pricing called the Arbitrage Pricing Theory (APT) has been introduced. Essence of APT A securitys expected return and risk are directly related to its sensitivities to changes in one or more factors (e.g., inflation, interest rates, productivity, etc.)
In other words, security returns are generated by a single-index (one factor) model:
wh e re p
x
j1 m j1
j j
wh e re 1,p
x
j1
j 1, j
2 ( p )
2 x2 j ( j )
2 ( p )
j1
2 x2 j ( j )
As su m i n g C O V( j , k ) 0
As su m i n g C O V( j , k ) 0
Two Factors
rj,t A j 1, jI1,t 2, jI 2,t j,t E(r j ) E(rz ) [E(I1 ) E(rz )]1, j [E(I 2 ) E(rz )] 2, j
2 2 2 2 2 2 (rp ) 1, (I ) (I ) (p ) p 1 2,p 2
rj,t A j 1, jI1,t 2, jI 2,t . . . + n, jI n, t + j,t E(r j ) E(rz ) [E(I1 ) E(rz )]1, j [E(I 2 ) E(rz )] 2, j +.... + [E(I n ) E(rz )]n, j
2 2 2 2 2 2 2 2 (rp ) 1, (I ) (I ) . . . + (I ) + ( p ) p 1 2,p 2 n, p n
B E(rZ)1 E(rZ)2
0 -0.5 0 0.5 1 1.5
Factor Beta
approximately linear. That is, the absence of arbitrage opportunities does not ensure exact linear pricing. There may be a few securities with expected returns greater than, or less than, those specified by the APT equation. However, because their number is fewer than that required to drive residual variance of the portfolio to zero, we no longer have a riskless arbitrage opportunity, and no market pressure forcing their expected returns to conform to the APT equation.
P Equilibrium Line A
Beta
1 1.5 2 2.5
will rise causing E(rB) to fall. Arbitrage opportunities will no longer exist when all assets lie on the same straight line.
E(r j )
Anticipate d Return
rj,t = E(rj) If (I1,t) is not equal to E(I1), or (j,t) is not equal to zero, then some unanticipated return (positive or negative) will be received.
E(rZ ) .06 E(I 1 ) .12 I1,t .15 j,t .01 1, j .5 Expected Return: E(r j ) E(rZ ) [E(I1 ) E(rZ )]1, j
.03
0.03
0.12
E(I1)
0.15 I1,t
0.18
0.21
M,I2 rM,t
Consider APT for a Two Factor Model: E(rj ) E(rZ ) [E(I1 ) E(rZ )]1, j [E(I 2 ) E(rZ )]2, j In terms of the CAPM, we can treat each of the factors in
the same manner that individual securities are treated: (See charts above)
CAPM Equation:
Note that M,I1 and M,I2 are the CAPM (market) betas of
factors 1 and 2. Therefore, in terms of the CAPM, the expected values of the factors are: E(I 1 ) E(rZ ) [E(rM ) E(rZ )] M, I 1 Equation1
E(I 2 ) E(rZ ) [E(rM ) E(rZ )] M, I 2 Equation2 By substituting the right hand sides of Equations 1 and 2 for E(I1) and E(I2) in the APT equation, we get:
E(r j ) E(rZ ) ([E(rM ) E(rZ )] M, I 1 ) 1, j + ([E(rM ) E(rZ )] M, I 2 ) 2, j E(r j ) E(rZ ) [E(rM ) E(rZ )]( M, I 11, j M, I 2 2, j ) Note th at: M, j M, I 11, j M, I 2 2, j S i n ce: E(r j ) E(rZ ) [E(rM ) E(rZ )] M, j
CAPM beta (M,j), but have different APT betas relative to the factors (1,j and 2,j). Consistency of the APT and CAPM (an example) Given: Factor 1 (Productivity) M,I1 = .5 Factor 2 (Inflation) M,I2 = 1.5
M,I1 1,j + M,I2 2,j = M,j ___________________ .5(0) + 1.5(.667) = 1.00 .5(.4) + 1.5(.534) = 1.00 .5(.8) + 1.5(.400) = 1.00 .5(1.2) + 1.5(.267) = 1.00 .5(1.6) + 1.5(.134) = 1.00 .5(2.0) + 1.5(0) = 1.00
Assuming the market is efficient, all of the securities (1 through 6) will have equal returns on the average over time since they have a CAPM beta of 1.00. However, some would argue that it is
not necessarily true that a particular investor would consider all securities with the same expected return and CAPM beta equally desirable. For example, different investors may have different sensitivities to inflation. Note: It is possible for both the CAPM and the multiple factor APT to be valid theories. The problem is to prove it.
supporting or contradicting APT. Furthermore, the number of factors to be included in APT models has varied considerably among studies. In one example, a study reported that most of the covariances between securities could be explained on the basis of unanticipated changes in four factors: Difference between the yield on a long-term and a short-term treasury bond. Rate of inflation Difference between the yields on BB rated corporate bonds and treasury bonds. Growth rate in industrial production.
Is APT Testable?
Some question whether APT can ever be
tested. The theory does not specify the relevant factor structure. If a study shows pricing to be consistent with some set of N factors, this does not prove that an N factor model would be relevant for other security samples as well. If returns are not explained by some N factor model, we cannot reject APT. Perhaps the choice of factors was wrong.
using the following factors: Monthly return to U.S. T-Bills Difference between the monthly returns on long-term and short-term U.S. Treasury bonds. Difference between the monthly returns on long-term U.S. Treasury bonds and low-grade corporate bonds with the same maturity. Monthly change in consumer price index. Monthly change in U.S. industrial production. Dividend to price ratio of the S&P 500.
he found that the APT did appear to have only limited predictive power regarding returns. He argues that the arbitrage process is extremely difficult in practice. Since covariances (betas) must be estimated, there is uncertainty regarding their values in future periods. Therefore, truly risk-free portfolios cannot be created using risky stocks. As a result, pure riskless arbitrage is not readily available limiting the usefulness of APT models in predicting future stock returns.