CH 10 Multifactor Models of Risk and Return

Arbitrage Pricing Theory and
Multifactor Models of
Risk and Return
Single Factor Model
 Returns on a security come from two
sources:
 Common macro-economic factor
 Firm specific events
 Possible common macro-economic factors
 Gross Domestic Product Growth
 Interest Rates
Single Factor Model Equation
ri  E (ri )  i F  ei
ri = Return on security
βi= Factor sensitivity or factor loading or factor
beta
F = Surprise in macro-economic factor
(F could be positive or negative but has
expected value of zero)
ei = Firm specific events (zero expected value)
10-3
Multifactor Models
 Use more than one factor in addition to

market return
 Examples include gross domestic
product, expected inflation, interest
rates, etc.
 Estimate a beta or factor loading for
each factor using multiple regression.
10-4
Multifactor Model Equation
ri  E ri    iGDP GDP   iIR IR  ei
ri = Return for security i

βGDP = Factor sensitivity for GDP
βIR = Factor sensitivity for Interest Rate
ei = Firm specific events
10-5
Multifactor SML Models
E ri   rf   iGDP RPGDP   iIR RPIR
i
GDP = Factor sensitivity for GDP
RPi GDP = Risk premium for GDP
IR = Factor sensitivity for Interest Rate
RPIR = Risk premium for Interest Rate
10-6
Interpretation
1.The risk-free rate
The expected return 2.The sensitivity to GDP
on a security is the times the risk premium
sum of: for bearing GDP risk
3.The sensitivity to
interest rate risk times
the risk premium for
bearing interest rate
risk
10-7
Arbitrage Pricing Theory
 Arbitrage occurs if Since no investment
there is a zero is required, investors
investment portfolio can create large
with a sure profit. positions to obtain
large profits.
10-8
Arbitrage Pricing Theory
 Regardless of wealth  In efficient markets,
or risk aversion, profitable arbitrage
investors will want an opportunities will
infinite position in the quickly disappear.
risk-free arbitrage
portfolio.
10-9
APT & Well-Diversified Portfolios
rP = E (rP) + bPF + eP
F = some factor
 For a well-diversified portfolio, eP

 approaches zero as the number of securities
in the portfolio increases
 and their associated weights decrease
10-10
Figure 10.1 Returns as a Function of
the Systematic Factor
10-11
Figure 10.2 Returns as a Function of the
Systematic Factor: An Arbitrage Opportunity
10-12
Figure 10.3 An Arbitrage
Opportunity
10-13
Figure 10.4 The Security Market Line
10-14
APT Model
 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 can be extended to multifactor models.
10-15
APT and CAPM
APT CAPM
 Equilibrium means no  Model is based on an
arbitrage opportunities. inherently unobservable
 APT equilibrium is quickly “market” portfolio.
restored even if only a  Rests on mean-variance
few investors recognize efficiency. The actions of
an arbitrage opportunity.
 The expected return– many small investors
beta relationship can be restore CAPM
derived without using the equilibrium.
true market portfolio.  CAPM describes
equilibrium for all assets.
10-16
Multifactor APT
 Use of more than a single systematic
factor
 Requires formation of factor portfolios
 What factors?
 Factors that are important to
performance of the general economy
 What about firm characteristics?
10-17
Two-Factor Model
ri  E (ri )  i1 F1  i 2 F2  ei
 The multifactor APT is similar to the one-

factor case.
10-18
Two-Factor Model
 Track with diversified factor portfolios:
 beta=1 for one of the factors and 0 for all
other factors.
 The factor portfolios track a particular

source of macroeconomic risk, but are
uncorrelated with other sources of risk.
10-19
Where Should We Look for Factors?
 Need important systematic risk factors

 Chen, Roll, and Ross used industrial production,
expected inflation, unanticipated inflation, excess
return on corporate bonds, and excess return on
government bonds.
 Fama and French used firm characteristics that proxy
for systematic risk factors.
10-20
Fama-French Three-Factor Model
 SMB = Small Minus Big (firm size)

 HML = High Minus Low (book-to-market ratio)
 Are these firm characteristics correlated with
actual (but currently unknown) systematic risk
factors?
rit   i   iM RMt   iSMB SMBt   iHML HMLt  eit
10-21
The Multifactor CAPM and the APT
 A multi-index CAPM will inherit its risk

factors from sources of risk that a broad
group of investors deem important
enough to hedge
 The APT is largely silent on where to look
for priced sources of risk
10-22
Exercises and
Tutorial questions
 Chapter 10:
 2. 4. 9. 11
 CFA: 2, 3, 4

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CH 10 Multifactor Models of Risk and Return

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Arbitrage Pricing Theory and

 Use more than one factor in addition to

ri = Return for security i

 For a well-diversified portfolio, eP

 The multifactor APT is similar to the one-

 The factor portfolios track a particular

 Need important systematic risk factors

 SMB = Small Minus Big (firm size)

rit   i   iM RMt   iSMB SMBt   iHML HMLt  eit

 A multi-index CAPM will inherit its risk

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