Chapter Twelve: Arbitrage Pricing Theory
Chapter Twelve: Arbitrage Pricing Theory
Chapter Twelve: Arbitrage Pricing Theory
ARBITRAGE PRICING
THEORY
1
Background
Estimating expected return with the Asset
Pricing Models of Modern Finance
CAPM
Strong assumption - strong prediction
Corresponding Security
Market Line
B
C
Expecte
d
Return
Market
Index
A
x
Risk
(Return
Variability)
x
xx
x
xx
x
xx
x
x
x
x
xx
x
xx
Market
Beta
Corresponding Security
Market Cloud
Expecte
d
Return
Market
Index
Risk
(Return Variability)
Market Beta
FACTOR MODELS
ARBITRAGE PRICING THEORY (APT)
is an equilibrium factor model of security returns
Principle of Arbitrage
the earning of riskless profit by taking advantage of
differentiated pricing for the same physical asset or security
Arbitrage Portfolio
requires no additional investor funds
no factor sensitivity
has positive expected returns
Example
5
Expected Return
35%
25%
C
-3
E F
15%
B
5%
-1
-5%
-15%
3
Interest Rate Beta
A: E(r) = 4%;
With many combinations like this, you can create a riskfree portfolio with a 20% expected return. Then sell-short
the 16% and invest the proceeds in the 20% to arbitrage.
Expected Return
35%
E
25%
15%
C
5%
A B
-3
-1
-5%
-15%
3
Interest Rate Beta
FACTOR MODELS
ARBITRAGE PRICING THEORY (APT)
Three Major Assumptions:
capital markets are perfectly competitive
investors always prefer more to less wealth
price-generating process is a K factor model
11
FACTOR MODELS
MULTIPLE-FACTOR MODELS
FORMULA
ri = ai + bi1 F1 + bi2 F2 +. . .
+ biKF K+ ei
where r is the return on security i
b is the coefficient of the factor
F is the factor
e is the error term
12
FACTOR MODELS
SECURITY PRICING
FORMULA:
ri = 0 + 1 b1 + 2 b2 +. . .+ KbK
where
ri = rRF +(1rRFbi12rRF)bi2+
rRFbiK
13
FACTOR MODELS
where
is the factor
is the error term
14
FACTOR MODELS
hence
a stocks expected return is equal to the risk
free rate plus k risk premiums based on the
stocks sensitivities to the k factors
15