Arbitrage Pricing Theory

Learning outcomes
After the lecture students are expected to:
Understand the APT model and critique
it
Compute the price of a security using
APT
Understand the SI model and critique it
Compute the price of a security using
SIM.
 Arbitrage Pricing Theory
The CAPM was criticized by Richard Roll and
others on the basis that it is entirely dependent on
the existence of a "market Portfolio" of risky
assets. They contended that this such a portfolio
does not exist in practice. Ross and others
developed an alternative based on the following
simplifying assumptions:
1. Capital markets are perfectly competitive,
2. Investors always prefer more wealth to less
wealth,
APT

 In APT, the assumption of investors utilizing a

mean-variance framework is replaced by an
assumption of the process of generating security
returns.
 APT requires that the returns on any stock be
linearly related to a set of indices.
 In APT, multiple factors have an impact on the
returns of an asset in contrast with CAPM model
that suggests that return is related to only one
factor, i.e., systematic risk
Factors that have an impact the returns of
all assets may include inflation, growth in
GNP, major political upheavals, or changes
in interest rates
ri = ai + bi1F1 + bi2F2 + …+bikFk + ei
Given these common factors, the bik terms
determine how each asset reacts to this
common factor.
 While all assets may be affected by growth in
GNP, the impact will differ.
 Which firms will be affected more by the growth
in GNP?
 The APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic risk
portfolio is zero, when the unique effects are
diversified away:
 E(ri) = 0 + 1bi1 + 2bi2 + … + kbik
Examples of such factors include:
· inflation,
· growth rate in the GDP,
· major political upheavals,
· changes in interest rates,
· etc,
Example from module
Single Index Model(Excess R)

 The single-index model (SIM) is a simple asset

pricing model to measure both the risk and the
return of a stock, commonly used in the finance
industry
 It is a Simplified version of Sharpe’s Market
Model
 Decompose returns into market and active
components.
 Postulate that active components are
uncorrelated.
SIM cont

Mathematically the SIM is expressed as:

Rit - rf = α + β (Rm – rf ) + ε
where:rit is return to stock i in period t
rf is the risk free rate (i.e. the interest rate on
treasury bills)
rmt is the return to the market portfolio in
period t is the stock's alpha, or abnormal
return
SIM cont

 β is the stock`s beta co efficient, or

responsiveness to the market return.
 Note that Rm – rf is called the excess return on
the market, Rit - rf the excess return on the
stock are the residual (random) returns.
 This can be reduced to a linear function:
Y = α + βX + ε
SIM cont

 These equations show that the stock return is

influenced by the market (beta), has a firm
specific expected value (alpha) and firm-specific
unexpected component (residual). Each stock's
performance is in relation to the performance of a
market index (such as the All Ordinaries).
Security analysts often use the SIM for such
functions as computing stock betas, evaluating
stock selection skills, and conducting event
studies.
Assumptions SIM

To simplify analysis, the single-index

model assumes that there is only 1
macroeconomic factor that causes the
systematic risk affecting all stock returns
and this factor can be represented by the
rate of return on a market index, such as
the ZSE.
Assumptions SIM

 According to this model, the return of any stock

can be decomposed into the expected excess
return of the individual stock due to firm-specific
factors, commonly denoted by its alpha
coefficient (α), the return due to macroeconomic
events that affect the market, and the unexpected
microeconomic events that affect only the firm.
 Most stocks have a positive covariance because
they all respond similarly to macroeconomic
factors.
Assumptions SIM

 However, some firms are more sensitive to these factors

than others, and this firm-specific variance is typically
denoted by its beta (β), which measures its variance
compared to the market for one or more economic
factors.
 Covariances among securities result from differing
responses to macroeconomic factors. Hence, the
covariance of each stock can be found by multiplying
their betas and the market variance:
 The single-index model assumes that once the market
return is subtracted out the remaining returns are
uncorrelated:
 The Market Model
E  Ri   R f  i  E  Rm   R f  Single-index model

The difference between expected

Ri  R f  i  Rm  R f   ei
returns and realized returns is
attributable to an error term, ei.

The market model: the intercept, αi, and slope

coefficient, βi, can be estimated by using
Ri  i  i Rm  ei historical security and market returns. Note αi
= Rf(1 – βi).
 Decomposition of Total Risk for a
Single-Index Model
R i  R f  i R m  R f   e i

Total variance = S ystematic variance + Nonsystematic variance

i2  i2 m2  ei2  2Cov R m , e i   i2 m2  ei2

Zero
Example - see handout
 Risk Reduction with
Diversification
St. Deviation
Unique Risk
2(eP)=2(e) / n

P2M2
Market Risk

Number of
Securities
Single Factor Model

Solves the number of parameters problem:

– For N assets, it requires N+1 parameters.
– N active risks, 1 market volatility.
Problem with this model: it doesn’t
capture observed correlation structure in
the market. Are EWZ and Delta correlated
only through their market exposure?
Advantage: simplicity makes this useful
for back-of-the-envelope calculations.
The CAPM and the Index Model

 Actual Returns vs Expected Returns

– CAPM is a statement about ex ante or expected
returns whereas all we can observe are actual or
realized holding period returns.
– To make a leap from expected to realized returns, we
can employ the index model.
– The index model beta turns out to be the same beta of
CAPM expected return-beta relationship, except we
place an observable market index instead of the
theoretical market portfolio.
The CAPM and the Index Model

The Index model and the expected return-

beta relationship.
– CAPM:
E(ri)-rf= ßi[E(rm)- rf]
– If the index M is the true market portfolio, we
can take the expectation of each side of the
equation Ri = αi + ßi(Rm) + ei.

E(ri)-rf= αi +ßi[E(rm)- rf]

The CAPM and the Index Model

 If we compare it with CAPM equation the only

difference is αi. CAPM predicts that αi should be
zero for all assets. The alpha of a stock is
expected return in excess of the fair expected
return as predicted by CAPM. If the stock is
fairly priced, its alpha must be zero.
 If we estimate the index model for several firms,
using regression equation, we should find expost
(realized) alphas average will be zero.
The CAPM and the Index Model

CAPM states that the expected value of

alpha is zero for all securities.
Index model states that realized value of
alpha should average zero.
Jensen examine the alphas realized by
mutual funds and found that frequency
distribution of these alphas seem to be
distributed around zero.
Example

See hand out