PART 1 & 2

Investment is the current commitment of dollars for a period of time in order to derive future payments that
will compensate the investor for:

(1) The time the funds are committed

(2) inflation during this time

(3) uncertainty of the future payments

“investor” can be : household or individual, corporation, gvt, non-profit organization

types of investments: in plant and equipment(corporations), real estate, stocks, bonds

!! We will focus on stocks and T bills !!

The portfolio theory aims to evaluate individual investments by their contribution to the risk and return of
an investor’s stocks.

Harry Markowitz  unless the returns of the risky assets are perfectly positively correlated, risk is reduced
by diversifying across assets.

Treynor, Sharpe, Mossin, and Lintner modern portfolio theory (MPT)

PART I. PORTFOLIO THEORY CONCEPTS AND ISSUES (RETURN , RISK AND DI VE R S I

F I C A TI ON )
1/PORTFOLIO MANAGEMENT PROCESS STEPS:
Step 1: The planning step: determine details regarding the investor’s risk tolerance, return objectives, time
horizon, tax exposure and any unique circumstances or investor preference.

Step 2: The execution step: analysis of the risk and return characteristics of various asset classes to
determine how funds will be allocated to the various asset types. Analyze the current and the estimated
economic situation; inflation, GDP growth, interest rate..( top-down analysis)

Step 3: The feedback step: over time investors preferences may change, thus, risk and return characteristics
of asset classes will change  the actual weights of the assets in the portfolio will change also  monitor
these modifications and rebalance the portfolio characteristics

2/Types of investors:

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3/Major return measures:
A. Holding period return (HPR): percentage increase in the value of an investment over a given
time period.

B. Average Returns :

Arithmetic mean return: average of a series of periodic returns, unbiased estimator.

Geometric Mean Return: a compounded annual rate, < arithmetic when periodic rates vary

C. Other Returns:

Gross Return: total return on a security portfolio before deducting fees / Net Return: return after deducting
fees/ Real Return: adjusted for inflation / Leveraged Return: gain or loss on the investment as a percentage
of an investor’s cash investment (derivative security )

4/Characteristics of the major asset classes: we look at historical risk and returns :
Stocks = corporate ownership,

bonds =long- term fixed- income securities, (bondholders face the risk that inflation will reduce the
purchasing power of their cash flows: fixed interest rate paid out periodically However inflation rises over
time)

Treasury bills = short- term government debt securities (generally safe but long- term bonds are risky
because of possible changes in interest rates).

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A tradeoff between risk (Variance, Standard deviation: Probability that the return diverges from the
expected return.) and return (Mean: Measure of central tendency.).

!!!!!! Using only the mean and variance when we evaluate an investment, we are making two important
assumptions:

1. Returns are normally distributed and can be fully characterized by their means and variances

2. Markets are informationally and operationally efficient.

major asset classes in the US

Small cap stocks refer to companies with a market capitalization typically between less then $2 billion,
generally newer and smaller than their large cap counterparts (>$10 billion), and they often have a greater
potential for growth, but they tend to be riskier.

“Risk–return trade- off”: refers to the positive relationship between expected risk and return. In efficient
markets, higher return is not possible to attain without accepting higher risk. (indicator of risk aversion)

Risk premium: the extra return investors can expect for assuming additional risk, calculated as the difference
between the expected return on a risky asset and the risk-free rate of return

(The nominal risk-free interest rate is the rate of return on an investment that is assumed to have no risk of
default, real is adjusted for inflation)

Apart from risk and return, Liquidity is another feature to consider when selecting investments because it
affects prices and, therefore, the expected return of a security. Liquidity can be a major concern in emerging
markets and for securities that trade infrequently, such as low-quality corporate bonds.

5/ Return and Risk assessment based on historical data:

5.1. Historical Mean Return and Expected Return

Historical return obtained from the actual return that was earned by an investor in the past.

Expected return is what an investor anticipates to earn in the future. The nominal return that would cause
investors to invest in an asset based on the real risk- free interest rate Rf (>0 as compensation for
postponing consumption: not using the money now but use it later when there is higher inflation), expected
inflation E(π) (>0), and expected risk premium for the risk of the asset E(RP) (>0).

Considering a long enough period of time, we can expect that the future (expected) return will equal the
average historical return (not very accurate.). E(R) =R̅

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 Return of a stock i: E(Ri) = ∑ Ri/N (histrocial data = ∑ PiRi (future data) , Pi= probability of Ri occurring

Return of a portfolio P:{stock1, stock2, ... ,stock n} : E(Rp) = ∑WiE(Ri) , Wi is the weight of the stock i in
the portfolio P

5.2. Variance (Standard Deviation) of Returns for an Individual Security

Population variance: when we know the return Rt Sample variance: using a sample of T historical
for each period, the total number periods (T ), and returns and the mean R̅
the mean (μ)

5.3. Covariance and Correlation of Returns for Two Securities: measures the extent to which they move
together over time.

ρ1,2 is called the correlation coefficient between the returns of securities 1 and 2, It is a pure and
standardized measure of the co-movement of the two stocks’ returns, has no units and -1< ρ1,2 <1

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6/ Risk aversion and its implications for portfolio selection :
Risk aversion is related to the behavior of individuals under uncertainty.

i. Risk Seeking: If an investor chooses the gamble. would maximize both risk and return. The
gamble has an uncertain outcome, but with the same expected value as the guaranteed
outcome. Thus, an investor choosing the gamble means that the investor gets extra “utility”
from the uncertainty associated with the gamble. Sometimes, risk seekers will accept less return
because of the risk that accompanies the gamble
ii. Risk Neutral: an investor is indifferent about the gamble or the certain outcome, Risk neutrality
means that the investor cares only about return and not about risk, higher return investments
are more desirable even if they come with higher risk.
iii. Risk Averse: If an investor chooses the guaranteed outcome, investors are likely to shy away
from risky investments for a lower, but guaranteed return.

 Risk averse wants to minimize their risk for the same return, and maximize their return
for the same risk.
 Risk Neutral wants to maximize return irrespective of risk

 Risk seeker wants to maximize both risk and return ⚠

Risk tolerance refers to the amount of risk an investor can tolerate to achieve an investment goal  risk
tolerance is negatively related to risk aversion

7/ Calculate and interpret portfolio standard deviation :

[variance=(std deviation)²]
The variance of returns for a portfolio of two risky assets is calculated as follows:

Where w1 and w2 are the weights of stock1 and stock2 respectively, w2 must equal (1 − w1).
The formula can be written in term of correlation coefficient as follow:

⚠ We agreed that we can calculate the risk in terms of standard deviation also(facilitate the
detection of the effect of the correlation of returns between the two assets on portfolio risk.)

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8/ The effect of investing in less than perfectly correlated assets on a portfolio’s risk:

In fact, the lower the correlation of asset returns, the greater the risk reduction benefit of
diversifing assets in a portfolio. (as long as the correlation is less than 1 there will be some
benefits to diversifying assets in a portfolio)
If asset returns were perfectly negatively correlated, portfolio risk could be eliminated
altogether for a specific set of asset weights.

9/ the minimum-variance and efficient frontiers of risky assets and the global minimum-
variance portfolio :
For each level of expected portfolio return, we may modify the asset weights to determine the
portfolio that has the least risk.
The portfolios with lowest standard deviation(risk) of all portfolios for a specific expected return
are known as minimum-variance portfolios All together they make up the minimum-
variance frontier.
The portfolios with greatest expected return for each level of risk (standard deviation) make up
the efficient frontier. The portfolio on the efficient frontier that has the least risk is the global
minimum-variance portfolio.
A risk-averse investor (rational investor) would only choose portfolios that are on the efficient
frontier.

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For different combination of weights, we plot the E(R) and std deviation of the portfolio,

⚠ The efficient frontier is the top portion of the

minimum-variance frontier.
10/the selection of an optimal portfolio, given an investor’s utility (or risk aversion) and the
capital allocation line :
10.1. Utility function of investors: represents the investor’s preferences in terms of risk
and return (i.e., his degree of risk aversion). Utility is a measure of satisfaction that an investor
derives from a portfolio.
In general utility theory allows us to quantify the rankings of investment choices using risk and
return.
Assumptions:

✓ investors are risk averse. ✓ prefer greater return to less return

✓ can rank different portfolios in the order of their preference and rankings are internally
consistent. (prefers X to Y and Y to Z, then must prefer X to Z). This property implies that the
indifference curves for the same individual can never touch or intersect.
10.2. Indifference Curves: tool from economics that plots combinations of risk–return
pairs among which an investor is indifferent. combinations investor would accept to maintain a
given level of utility.
 investor is indifferent if risk or return
increases from a to b
investor will prefer any portfolio along 1( high
utility) to any portfolio on either 2(moderate
utility) or 3 (low utility).

⚠ investor’s expected utility is the same for all

points along a single indifference curve.
10.3. Capital allocation Line (CAL):
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we will consider the risk and return characteristics of a portfolio that combines a portfolio of risky assets and
the risk-free asset (issued by the gvt), before that we only considered risky assets  this makes the
investment opportunity set much richer.

▪The risk- free asset has zero risk and a return of Rf 𝜎𝑅𝑓 = 0 σi> 𝜎𝑅𝑓 →E(Ri) > Rf
▪ The risky asset has a risk of σi (> 0) and an expected return of E(Ri)

Retun of the portfolio : 𝐸(𝑅𝑝) = 𝑤1𝑅𝑓 + (1 − 𝑤1 )𝐸(𝑅𝑖)

The risk of the portfolio :

If we put X% of our portfolio into

the risky asset portfolio, the resulting portfolio will have standard deviation of returns equal to X% of the
standard deviation of the risky asset :

The capital allocation line represents the portfolios

available to an investor from all possible
combinations of risk-free assets and the optimal
risky asset portfolios. All optimal investor
portfolios must be on this line.

The two-fund separation theorem: all investors’

optimum portfolios will be made up of some
combination of an optimal portfolio of risky assets
and the risk-free assets. allows us to divide an
investor’s investment problem into two distinct steps: the investment decision and the financing decision.

In the first step, as in the previous analysis, the investor identifies the optimal risky portfolio. The optimal
risky portfolio is selected from numerous risky portfolios without considering the investor’s preferences,
based on return, risk, and correlations.

In the second step, the investor’s risk preference (deduced using indifference curves) determines the
amount of financing i.e. lending to the government by buying risk- free asset instead of investing in the
optimal risky portfolio or borrowing to purchase additional amounts of the optimal risky portfolio (Portfolios
beyond the optimal risky portfolio are obtained by borrowing at the risk- free rate)

we can combine the CAL with indifference curves representing an individual’s preferences for risk and
return to demonstrate the logic behind the selection of an optimal portfolio (one that maximizes the
investor’s expected utility).

We can observe that an Investor (A), with preferences represented by

indifference curves I1, I2, and I3, may attain the level of expected utility
on I2 by choosing portfolio X  this is the optimal portfolio for this
investor, portfolios that lie on I2 is preferred to all portfolios that lie on I3
however portfolios on I1 are preferred to those on I2, but the portfolios
those are not available in the market.

Investment Opportunity Set : two assets are perfectly correlated =>

straight line of achievable portfolios formed by changing the weights. As the
number of available assets increases, the number of possible combinations
increases rapidly constructing an opportunity set of investments.

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 All points on the curve and points to the right of the curve are attainable by a combination of one or
more of the investable assets. This set of points is called the investment opportunity set.

⚠ here we are talking about minimum variance frontier curve

Risk- averse investor will choose to invest in a portfolio to the right of the minimum- variance frontier
because a portfolio on the minimum- variance frontier can give the same return but at a lower risk, but
investors also want to maximize return for a given risk.

An investor cannot hold a portfolio consisting of risky assets that has less risk than that of the global
minimum- variance portfolio.

All portfolios on the efficient frontier are candidates for being

combined with the risk- free asset.

CAL(A) combination between risk free asset and efficient

portfolio A

CAL(P) combination between risk free asset and efficient

portfolio P

the portfolios on CAL(P) dominate the portfolios on CAL(A) =>

rational investor choses CAL(P)

With the addition of the risk- free asset, we are able to narrow our selection of risky portfolios to a single
optimal risky portfolio, P, which is at the tangent of CAL(P) and the efficient frontier of risky assets.

Adding the indifference curve can help to select the optimal

portfolio. Thus, the optimal portfolio for the investor with this
indifference curve is portfolio C on CAL(P), which is tangent to the
indifference curve.

The optimal (CAL) for any investor is the one that is just tangent to
the efficient frontier.

PART II. PORTFOLIO THEORY MAKOVITZ SELECTION: RISK AND RETURN

1/ Explain the capital allocation line (CAL) and the capital market line (CML) :
(CAL) includes all possible combinations of the risk- free asset and an investor’s optimal risky portfolio.

The capital market line (CML) is a special case of the CAL where the risky portfolio is the market portfolio.

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Obviously, if each investor has different expectations about the expected returns, standard deviations, or
correlations between risky asset returns, each investor will have a different optimal risky asset portfolio and
a different CAL  simplifying assumption is that investors have homogeneous expectations, all face the
same efficient frontier of risky portfolios and will all choose the same optimal risky portfolio and CAL, that
portfolio must be the market portfolio.

The market portfolio is the point on the Markowitz efficient frontier where
a line from the risk- free asset is tangent.

𝑃 = {𝑅𝑓, 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 (𝑀)}

Risk free asset 𝑅𝑓: Debt security, No default risk, No inflation risk, No interest
rate risk, No liquidity risk, No risk of any other kind (US Treasury bills are
usually used as a proxy of the risk- free return, Rf)

Market portfolio M: the risky portfolio The S&P 500 is a proxy of the market portfolio.

Return: 𝐸(𝑅𝑝) = 𝑤1𝐸(𝑅𝑚) + (1 − 𝑤1)𝑅𝑓

𝐸(𝑅𝑝) = 𝒘𝟏𝐸(𝑅𝑚) + 𝑅𝑓 − 𝒘𝟏𝑅𝑓

𝑬(𝑹𝒑) = 𝑹𝒇 + [𝑬(𝑹𝒎) − 𝑹𝒇 ] 𝝈𝒑/𝝈𝒎: Capital Market Line (CML)
𝐸(𝑅𝑝) = 𝑹𝒇 + 𝒘𝟏 ([𝑬(𝑹𝒎) − 𝑹𝒇 ] (𝟏)
equation
Risk: 𝜎𝑝 = 𝑤1𝜎𝑚  𝒘𝟏 = 𝜎𝑝/𝜎𝑚 (2)

Market risk premium: 𝐸(𝑅𝑚) – 𝑅𝑓

[𝑬(𝑹𝒎) − 𝑹𝒇]/𝝈𝒎 is the slope of CML, called the market price of risk because it indicates the market risk
premium for each unit of market risk 𝝈𝒎 an investor is willing to
accept.

If we assume that investors can both lend (invest in the risk-free asset)
and borrow (as with a margin account) at the risk-free rate, they can
select portfolios to the right of the market portfolio: They can borrow
at the risk-free rate to increase their investment in the market
portfolio, or lend at the risk-free rate to decrease their investment in
the market portfolio  they can increase their expected return
without increasing their risk, as the risk-free rate is considered to be a
riskless investment. (Weights change)

2/ systematic and nonsystematic risk :

we will highlight the question of pricing the risk by decomposing the total risk of a security or a portfolio into

Systematic risk : known as non- diversifiable or market risk, cannot be avoided and is inherent in the overall
market.

Systematic risk can be magnified through selection or by using leverage (When an investor selects securities
that are highly correlated, or when using leverage (i.e., borrowing money to invest) can amplify the returns
of the portfolio, both positive and negative). It can be diminished by including securities that have a low
correlation with the portfolio.

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Nonsystematic risk : risk that pertains to a single company or industry and is also known as company-
specific, industry specific, diversifiable, or idiosyncratic risk. Examples could include the failure of a drug trial
or an airliner crash. This risk could be avoided through diversification by forming a portfolio of assets that
are not highly correlated with one another.

Portfolio’s risk declines gradually as stocks are added.

⚠ we don’t need to buy all the securities in the market to eliminate

nonsystematic risk, we need 12 to 18 stocks in a portfolio to achieve 90% of
the maximum diversification possible. Another study indicates it took 30
securities.

The required rate of return on a stock or a portfolio should exclusively

compensate its systematic risk, no compensation for the individual risk
because it can be eliminated “for free” through diversification.

3/ Return generating models :

Used to estimate the expected returns on risky securities based on specific factors. Financial literature
distinguishes between : Multifactor models, single-index model.

The Market model : a simplified form of a single-index model used to estimate a security’s beta and to
estimate its abnormal return (what’s above expected return). Introduced by Sharpe (1963) based on the
principle that stock returns are correlated due to their common dependence to the market movements. If
the market index increases most of the stock returns will increase.

𝑹𝒊,𝒕 : return of stock i during time t 𝜶𝒊 : intercept/constant term

𝑹𝒎,𝒕 : Return of the market at time t 𝜺𝒊,𝒕 : residual term at time t

𝜷𝒊 : Slope of the regression line : measure the sensitivity of the return of stock i to the market return
movements.

4/ Calculate and interpret beta :

It is the sensitivity of an asset’s return to the return on the market index in the context of the market model.
measure of the systematic risk

𝜷𝒊 = 𝒄𝒐𝒗(𝑹𝒊 ,𝑹𝒎) /𝝈𝒎²

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 (by convention)

5/ The capital asset pricing model (CAPM) and the security market line (SML):
The model provides a linear expected return–beta relationship that precisely determines the expected
return given the beta of an asset. It assumes that the expected returns of assets vary only by their systematic
risk ( beta). We apply the CAPM to the pricing of securities : provides a benchmark rate of return for
evaluating possible investments/ helps us to make an educated guess for the expected return on the new
assets.

CAPM Assumptions: ✓ Investors are risk- averse, utility- maximizing, rational individuals ✓ Markets are
frictionless, including no transaction costs and no taxes. ✓ Investors plan for the same single holding period.
✓ Investors have homogeneous expectations or beliefs. ✓ All investments are infinitely divisible. ✓ Investors
are price takers

The CAPM uses this formula to calculate the expected return on an

investment: E(Ri) = Rf + Beta x (E(Rm)- Rf)  Two assets with the
same beta will have the same expected return irrespective of the
nature of those assets.

The security market line (SML) is a graphical representation of the

CAPM, the slope of this line is the market risk premium, Rm – Rf.

6/ Differences between CML and SML:

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8/ Portfolio performance measures:
Performance evaluation provides information about the return and risk of investment portfolios over a
specified investment period, it helps in understanding and controlling investment risk.

What was the investment portfolio’s past performance, and what may be expected in the future?
Total risk and
 performance measurement systematic risk
8.1. The Sharpe Ratio: A called the reward- to- variability ratio, defined as the portfolio’s risk premium are equal only
for efficient
divided by its risk. The Sharpe ratio can be calculated both before and after the fact. Ex ante Sharpe ratio isportfolios.
calculated before investing in a portfolio, using expected returns and standard deviation estimates. This
allows investors to evaluate the expected risk-adjusted return of a portfolio before investing. Can easily be
determined by using readily available market data.

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 Where : σp : the portfolio’s ex ante standard deviation of returns (return volatility) a
quantitative measure of total risk.

Ex post Sharpe ratio, on the other hand, is calculated after the investment period is over, using actual returns
and standard deviation values. This allows investors to evaluate historical risk adjusted returns. Assume we
have a sample of historical data that can be used to determine the sample mean portfolio return, Rp ; the
standard deviation of the sample returns, here denoted by σp; and the sample mean risk- free rate, Rf .

⚠ Sharpe ration is simply the slope of the capital allocation line. Note, however,
that the ratio uses the total risk of the portfolio, not its systematic risk.

8.2. The Treynor Ratio: Is a simple extension of the Sharpe ratio and resolves the Sharpe ratio’s first
limitation by substituting beta (systematic risk) for total risk.

⚠ Although both the Sharpe and Treynor ratios allow for ranking of
portfolios, neither ratio gives any information about the economic significance of differences in
performance. For example, assume the Sharpe ratio of one portfolio is 0.75 and the Sharpe ratio for another
portfolio is 0.80. The second portfolio is superior, but is that difference meaningful? In addition, we do not
know whether either of the portfolios is better than the passive market portfolio.

8.3. Jensen’s Alpha: Based on systematic risk.The difference between the actual portfolio return and the
calculated risk- adjusted return is a measure of the portfolio’s performance relative to the market portfolio
and is called Jensen’s alpha. By definition, αm of the market is zero. Jensen’s alpha is also the vertical
distance from the SML measuring the excess return for the same risk as that of the market and is given by:
αp = Rp − [Rf + βp[E(Rm) − Rf]]

Chapter: Index Models and Arbitrage Pricing Theory (APT)

The accumulation of evidence from the equity markets during the decades following the CAPM’s
development have provided clear indications that the CAPM provides an incomplete description of risk
and that models incorporating multiple sources of systematic risk more effectively model asset
returns.

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 1. Single index model-Multi factor Models:
1.1. A single index security market: ri = E(ri ) + mi + ei

Where: ▪ E(ri ): is the expected return on the security as of the beginning of the holding period

▪ mi : is the impact of unanticipated macroevents on the security’s return during a period

▪ ei : is the impact of unanticipated firm-specific events.

⚠ Both mi and ei have zero expected values because they are not anticipated.
we denote the unanticipated component of the macro factor by F, and denote the responsiveness of
security (i) to macroevents by beta 𝛽  𝒓𝒊 = 𝑬(𝒓𝒊 ) + 𝜷𝒊𝑭+𝒆𝒊 : single factor model for stock returns

We need to find a way to specify a measure for the factors that affect return => Single index model uses the
market index(S&P) to proxy for the common or systematic factor 𝑟𝑖 − 𝑟𝑓 = 𝛼𝑖 + 𝛽𝑖(𝑟𝑀 − 𝑟𝑓) + 𝑒𝑖

▪ 𝛼𝑖: stock’s expected return if the market is neutral(if the market excess return 𝑟𝑀 − 𝑟𝑓 is zero )
▪ 𝛽𝑖 (𝑟𝑀 − 𝑟𝑓): component of return due to movements in the overall market ; 𝛽𝑖 is the security’s
responsiveness to market movements
▪ 𝑒𝑖 unexpected component due to unexpected firm-specific events

⚠ The excess rate of return on the stock over the rf(𝑟𝑀 − 𝑟𝑓) , which measures the stock’s relative
performance, can be denoted as R  Ri = αi + βiRM + ei

Variance of the rate of return on security : 𝜎𝑖² = 𝛽𝑖²𝜎𝑀 ²+ 𝜎(𝑒𝑖)²

▪𝛽𝑖²𝜎𝑀²: uncertainty of the common macroeconomic factor

▪𝜎(𝑒𝑖)²: firm specific uncertainty

1.2. Multifactor models : Confining systematic risk to a single factor is not so accurate, the risk arises from a
number of sources like uncertainty about the business cycle, interest rates, and inflation. We will start with
two-factor model which focuses on GDP and IR. Thus the excess rate on a stock in a period t is as follows:

𝑹𝒕 = 𝜶+𝜷𝑮𝑫𝑷𝑮𝑫𝑷𝒕 + 𝜷𝑰𝑹𝑰𝑹𝒕 + 𝒆t

According to Fama French 3-Factor Model (1966) ,two classes of stocks tended to outperform the market as
a whole: small caps and high book-to-market ratio (explains over 90% of stock returns). They added these 2
factors to the equation

𝛽𝑖 = sensitivity of stock i to the excess

return of the market (market beta) 𝛽2 = sensitivity of stock i to the size factor (small minus big) SMB = return
on a portfolio of small stocks minus the return on a portfolio of big stocks (size premium) 𝛽3 = sensitivity of
stock i to the value factor (high minus low) HML = return on a portfolio of high book-to-market stocks minus
the return on a portfolio of low book-to-market stocks (value premium).

E(Ri) = the return on an asset in excess of the one-

month T- bill return, MKT = the excess return on the market portfolio , SMB = the difference in returns
between small- capitalization stocks and large capitalization stocks (size)small [market capitalization] minus

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big. When small stocks do well relative to large stocks this will be positive, and when they do worse than
large stocks, this will be negative. "Value" This is the return of value stocks minus growth stocks, which can
likewise be positive or negative, HML = the difference in returns between high- book- to- market stocks and
low book- to- market stocks (value versus growth) high [book/price] minus low

The Carhart four-factor model is a multifactor model that extends the Fama and French three-factor model
to include not only market risk, size, and value as relevant factors, but also momentum.

where: E(R) = expected return, RF = risk-free rate of return, RMRF = return on value-weighted equity index –
the risk-free rate, SMB = average return on small cap stocks – average return on large cap stocks, HML =
average return on high book-to-market stocks – average return on low book-to-market stocks, WML =
average returns on past winners – average returns on past losers

Chen, Roll and Ross 5 factors Model (1986) one of the most elaborated model, chose the following set of
factors:

▪IP:% change in
industrial production ▪ EI: % change in expected inflation ▪ UI:% change in unanticipated inflation ▪ CG:
excess return of long-term corporate bonds over long-term government bonds ▪ GB: excess return of long-
term government bonds over T-bills.

2. Macroeconomic factor models, fundamental factor models, and statistical factor models:
Many varieties of multifactor models have been proposed and researched. We can categorize most of
them into three main groups according to the type of factor used:

❖ Macroeconomic factor model: the factors are affecting either the expected future cash flows or the
interest rate used to discount (interest rates, inflation risk, business cycle risk, and credit spreads).
Macroeconomic models are based on the principle that return to an asset are correlated with surprises
in macroeconomic factors such as GDP, inflation...

A factor surprise is the actual value minus predictive value.

Ri = the return to stock I, ai = the expected return to stock I, bi1

= the sensitivity of the return to stock I to factor F (A factor sensitivity is a measure of the response of return
to each unit of increase in a factor, holding all other factors constant). FGDP = the surprise in factor F (Exp:
the surprise in GDP), εi = an error term with a zero mean that represents the portion of the return to asset I
not explained by the factor model.

❖ Fundamental factor model: the factors are attributes of stocks or companies that are important in
explaining differences in stock prices (book- value to- price ratio, market capitalization, the price- to-
earnings ratio, and financial leverage.)

the sensitivity in a fundamental factor model is an attribute of a security and expressed as standardized
beta.

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 ⚠ Unlike macroeconomic models, the factors represent returns instead of surprises in a fundamental
factor model. This means that the factors do not have expected values of zero and the intercept is not
the expected return to asset i.

❖ Statistical factor model: Applied to historical returns of a group of securities to extract factors that
can explain the observed returns of securities in the group. Two major types of factor models are factor
analysis models (the factors are the portfolios of securities that best explain historical return
covariances) and principal components models (factors are portfolios of securities that best explain the
historical return variances). This model makes minimal assumptions but its more difficult.

3. ARBITRAGE PRICING THEORY:

In 1976, Ross developed the arbitrage pricing theory (APT) as an alternative to the CAPM. APT introduced a
framework that explains the expected return of an asset/portfolio in equilibrium as a linear function of the
risk of the asset/portfolio with respect to a set of factors capturing systematic risk.

▪𝑹𝒊 : The return to asset I ▪ 𝒂𝒊 :An intercept term ▪

𝐼𝑘= the return to factor k, k = 1, 2, ..., K ▪ 𝒃𝒊𝒌= the
sensitivity of the return on asset i to the return to
factor k ▪ εi = an error term with a zero mean that
represents the portion of the return to asset i not explained by the factor mode.

⚠ APT assumes that financial markets are in equilibrium, similar to the CAPM it predicts a security
market line linking the expected return to risk, but the APT makes less strong assumptions :

 Security returns can be described by a factor model

 There are sufficient securities to diversify away idiosyncratic risk
 Well-functioning security markets do not allow for the persistence of arbitrage opportunities.

4. Define arbitrage opportunity and determine whether an arbitrage opportunity exists :

if the above three assumptions hold, the following equation holds:

𝑬(𝑹𝒑) = 𝑹𝒇 + 𝝀𝟏𝜷𝒑𝟏 + 𝝀𝟐𝜷𝒑𝟐 + ⋯ 𝝀𝒌𝜷𝒑𝒌 (𝑨𝑷𝑻 𝒆𝒒𝒖𝒂𝒕𝒊𝒐𝒏) 

▪ 𝐸(𝑅𝑝): 𝑡ℎ𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑝 ▪ 𝑅𝑓: The risk- free rate ▪ 𝜆𝑘 = The expected reward for
bearing the risk of factor k ▪ 𝛽𝑝𝑘=The sensitivity of the portfolio to factor k ▪ K = the number of factors

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⚠The factor risk premium (or factor price), λj , represents the expected reward for bearing the risk of a
portfolio with a sensitivity of 1 to factor j and a sensitivity of 0 to all other factors. A portfolio with a
sensitivity of 1 to factor j and a sensitivity of 0 to all other factors is called a pure factor portfolio for
factor j (or simply the factor portfolio for factor j) .

5. A comparison between two equilibrium models: APT and CAPM:

APT serves many of the same functions as the CAPM. It gives us a benchmark for rates of return, can be
used in capital budgeting, security evaluation, or investment performance evaluation.

=> APT highlights the crucial distinction between non-diversifiable risk (factor risk) that requires a
reward in the form of a risk premium and diversifiable risk that does not.

=>depends on the assumption that a rational equilibrium in capital markets prevents arbitrage.

APT does not fully dominate the CAPM. The CAPM provides an unambiguous statement on the expected
return-beta relationship for all securities, whereas the APT implies that this relationship holds for all but
perhaps a small number of securities. Because it focuses on the no-arbitrage condition.

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