Chapter

12

An Alternative View of Risk and Return: The

Arbitrage Pricing Theory

McGraw-Hill/Irwin

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills

Discuss the relative importance of systematic

and unsystematic risk in determining a
portfolios return
Compare and contrast the CAPM and
Arbitrage Pricing Theory

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Chapter Outline
12.1 Introduction
12.2 Systematic Risk and Betas
12.3 Portfolios and Factor Models
12.4 Betas and Expected Returns
12.5 The Capital Asset Pricing Model and the Arbitrage
Pricing Theory
12.6 Empirical Approaches to Asset Pricing

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APT

Arbitrage pricing theory (APT) is a well-known method of estimating the price of

an asset. The theory assumes an asset's return is dependent on various
macroeconomic, market and security-specific factors.
The general idea behind APT is that two things can explain the expected return on a
financial asset: 1) macroeconomic/security-specific influences and 2) the asset's
sensitivity to those influences
There are an infinite number of security-specific influences for any given security
including inflation, production measures, investor confidence, exchange
rates, market indices or changes in interest rates, RND, GNP, Rival Product e.t.c. It
is up to the analyst to decide which influences are relevant to the asset being
analyzed.
APT may be more customizable than CAPM, but it is also more difficult to apply
because determining which factors influence a stock or portfolio takes a
considerable amount of research. It can be virtually impossible to detect every
influential factor much less determine how sensitive the security is to a particular
factor. But getting "close enough" is often good enough

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Bahria Enterprises

Any Stock traded in Financial Markets has two parts.

A) Normal or Expected return(info available to SH & mkt undstding influence in
next month),
B) Uncertain or Risky Return (info that is to be reveled with in a month, list of
such info is endless)

News abt Bahria Reraserch

Sudden drop in interest

Discovery about Rivals product

News that sales figure are higher then expected

Un expected retirement of Founder and president

R= R+U where R is actual total return, R is expected, U is unexpected

part of return

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Expected Part of info and unexpected part of info e.g. GNP

diff b/w actual and forecast

Announcement = Expected part + surprise (innovation)

So the expected part is there part of info the mkt uses to form the
expectation R and the surprise is the news that influences the
unanticipated return on stock U.
Un anticipated part is the true risk of any investment. Because if we
got what is expected then there'll be no uncertainty

U is further categorized as Systematic Risk and Unsystematic risk.

S.Risk = is any risk affect large no. of assets, each to a greater or

lesser degree.
For e.g GNP, Inflation, interest rates

U.Srisk or idiosyncratic risk = Risk that specifically affects a single

asset or small group of assets. For e.g Rivals info, Retirement of
CEO, RnD
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= m+

where m is systematic or market risk,

company unique risk

is specific to company , is unrelated to specific risk of most other companies

Bahria

Entp specific risk is unrelated to Xerox stock. If Bahria's stock go up or down because of its new
discovery by RnD probably unrelated to Xerox so it mean both the stocks are uncorrelated with each other i.e.
Corr (b,

x)

But

companies are influenced by same systematic risk, individual companies systematic risks and
therefore total return as well.
Lecture

Tip: It is easy to see the effect of unexpected news on stock prices and returns. Consider the
following two cases: (1) On November 17, 2004 it was announced that K-Mart would acquire Sears in an $11
billion deal. Sears stock price jumped from a closing price of $45.20 on November 16 to a closing price of
$52.99 (a 7.79% increase) and K-Marts stock price jumped from $101.22 on November 16 to a closing price
of $109.00 on November 17 (a 7.69% increase). Both stocks traded even higher during the day. Why the jump
in price? Unexpected news, of course. (2) On November 18, 2004, Williams-Sonoma cut its sales and
earnings estimates for the fourth quarter of 2004 and its share price dropped by 6%. There are plenty of other
examples where unexpected news causes a change in price and expected returns.

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Risk: Systematic and Unsystematic

We can break down the total risk of holding a stock into
two components: systematic risk and unsystematic risk:
2
Total risk

Nonsystematic Risk:
Systematic Risk: m

R R U
becomes
R Rm
where
m is the systematic risk
is the unsystematic risk
n

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Systematic Risk and Betas

For example, suppose we have identified three

systematic risks: inflation, GNP growth, and the
interest rate change
Our model is:
R Rm
R R I FI GNP FGNP rFr
I is the inflation beta
GNP is the GNP beta
r is interest rate change
is the unsystematic risk

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Systematic Risk and Betas: Example

R R I FI GNP FGNP r Fr

Suppose we have made the following estimates:

I = 2
GNP = 1
S = -1.8

Finally, the firm was able to attract a superstar CEO, and this unanticipated
development contributes 1% to the return. 5%

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Arbitrage Pricing Theory

Arbitrage arises if an investor can construct
a zero investment portfolio with a sure
profit.

Since no investment is required, an investor

can create large positions to secure large
levels of profit.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.
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Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure
of total risk.
For well-diversified portfolios, unsystematic
risk is very small.
Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk.

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12.2 Systematic Risk and Betas

The beta coefficient, , tells us the response of the stocks return

to a systematic risk.
In the CAPM, measures the responsiveness of a securitys
return to a specific risk factor, the return on the market portfolio.

Cov ( Ri , RM )

( RM )
2

We shall now consider other types of systematic risk.

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Systematic Risk and Betas: Example

R R 2.30 FI 1.50 FGNP 0.50 FS 1%

We must decide what surprises took place in the

systematic factors.

If it were the case that the inflation rate was expected

to be 3%, but in fact was 8% during the time
period, then:
FI = Surprise in the inflation rate = actual expected
= 8% 3% = 5%
R R 2.30 5% 1.50 FGNP 0.50 FS 1%
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Systematic Risk and Betas: Example

R R 2.30 5% 1.50 FGNP 0.50 FS 1%

If it were the case that the rate of GNP growth

was expected to be 4%, but in fact was 1%,
then:
FGNP = Surprise in the rate of GNP growth
= actual expected = 1% 4% = 3%
R R 2.30 5% 1.50 (3%) 0.50 FS 1%
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Systematic Risk and Betas: Example

R R 2.30 5% 1.50 (3%) 0.50 FS 1%

If it were the case that the dollar-euro spot

exchange rate, S($,), was expected to
increase by 10%, but in fact remained stable
during the time period, then:
FS = Surprise in the exchange rate
= actual expected = 0% 10% = 10%
R R 2.30 5% 1.50 (3%) 0.50 (10%) 1%
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Systematic Risk and Betas: Example

R R 2.30 5% 1.50 (3%) 0.50 (10%) 1%

Finally, if it were the case that the expected return on

the stock was 8%, then:
R 8%
R 8% 2.30 5% 1.50 (3%) 0.50 (10%) 1%
R 12%

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12.3 Portfolios and Factor Models

Now let us consider what happens to portfolios of stocks when each of

the stocks follows a one-factor model.
We will create portfolios from a list of N stocks and will capture the
systematic risk with a 1-factor model.
The ith stock in the list has return:

Ri R i i F i
12-18

Relationship Between the Return on

the Common Factor & Excess Return
Excess
return

Ri R i i F i
If we assume
that there is no
unsystematic
risk, then i = 0.
The return on the factor F

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Relationship Between the Return on

the Common Factor & Excess Return
Excess
return

Ri R i i F

If we assume
that there is no
unsystematic
risk, then i = 0.

The return on the factor F

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Relationship Between the Return on

the Common Factor & Excess Return
Excess
return

A 1.5 B 1.0

Different
securities will
C 0.50 have different
betas.
The return on the factor F

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Portfolios and Diversification

We know that the portfolio return is the weighted average

of the returns on the individual assets in the portfolio:

RP X 1 R1 X 2 R2 X i Ri X N RN
Ri R i i F i

RP X 1 ( R1 1 F 1 ) X 2 ( R 2 2 F 2 )
X N ( R N N F N )
RP X 1 R1 X 1 1 F X 11 X 2 R 2 X 2 2 F X 2 2
X N R N X N N F X N N

12-22

Portfolios and Diversification

The return on any portfolio is determined by three sets
of parameters:
1. The weighted average of expected returns.
2. The weighted average of the betas times the factor.
3. The weighted average of the unsystematic risks.

RP X 1 R1 X 2 R 2 X N R N
( X 1 1 X 2 2 X N N ) F
X 11 X 2 2 X N N
In a large portfolio, the third row of this equation
disappears as the unsystematic risk is diversified away.

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Portfolios and Diversification

So the return on a diversified portfolio is
determined by two sets of parameters:
1.
2.

The weighted average of expected returns.

The weighted average of the betas times the factor
F.

RP X 1 R 1 X 2 R 2 X N R N
( X 1 1 X 2 2 X N N ) F
In a large portfolio, the only source of uncertainty is the
portfolios sensitivity to the factor.
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12.4 Betas and Expected Returns

RP X 1 R1 X N R N ( X 1 1 X N N ) F
P

RP
Recall that

and

R P X 1 R1 X N R N

P X 1 1 X N N

The return on a diversified portfolio is the sum of the expected

return plus the sensitivity of the portfolio to the factor.

RP R P P F

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Relationship Between & Expected

Return

If shareholders are ignoring unsystematic

risk, only the systematic risk of a stock
can be related to its expected return.
RP R P P F

12-26

Expected return

Relationship Between & Expected

Return

RF

SML
A

D
B
C

R RF ( R P RF )
12-27

12.5 The Capital Asset Pricing Model

and the Arbitrage Pricing Theory

APT applies to well diversified portfolios and

not necessarily to individual stocks.
With APT it is possible for some individual
stocks to be mispriced - not lie on the SML.
APT is more general in that it gets to an
expected return and beta relationship without
the assumption of the market portfolio.
APT can be extended to multifactor models.
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12.6 Empirical Approaches to Asset Pricing

Both the CAPM and APT are risk-based models.

Empirical methods are based less on theory and
more on looking for some regularities in the
historical record.
Be aware that correlation does not imply causality.
Related to empirical methods is the practice of
classifying portfolios by style, e.g.,

Value portfolio
Growth portfolio
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Quick Quiz

Differentiate systematic risk from unsystematic risk. Which type is essentially eliminated with well diversified portfolios?
Define arbitrage.
Explain how the CAPM be considered a special case of Arbitrage Pricing Theory?

12-30