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Chapter 9 - Multifactor Models of Risk & Return

The document summarizes the Arbitrage Pricing Theory (APT), an alternative multi-factor model for pricing assets and estimating returns. [1] The APT assumes asset returns can be predicted by macroeconomic factors rather than just the market portfolio. [2] It allows for multiple systematic risk factors like inflation and GDP growth rather than just one as in CAPM. [3] The APT provides a framework to estimate expected returns based on factor sensitivities and risk premia rather than relying on the single beta concept in CAPM.

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Imejah Favi
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338 views10 pages

Chapter 9 - Multifactor Models of Risk & Return

The document summarizes the Arbitrage Pricing Theory (APT), an alternative multi-factor model for pricing assets and estimating returns. [1] The APT assumes asset returns can be predicted by macroeconomic factors rather than just the market portfolio. [2] It allows for multiple systematic risk factors like inflation and GDP growth rather than just one as in CAPM. [3] The APT provides a framework to estimate expected returns based on factor sensitivities and risk premia rather than relying on the single beta concept in CAPM.

Uploaded by

Imejah Favi
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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LCASTOL

CHAPTER 9
Multifactor Models of Risk and Return
LEARNING OBJECTIVES

Learning Objectives
• Explain the deficiencies of the capital asset pricing model
(CAPM)
• Explain the arbitrage pricing theory (APT) and how it is
similar and different from CAPM
• Enumerate the strengths and weaknesses of the APT as a
theory of how risk and expected return are related
• Explain how can the APT be used in the security valuation
process
CRITICISMS OF CAPM
Criticisms of CAPM
• The many unrealistic assumptions
• Information is freely available to investors
• Investors have the same expectations and are risk
averse
• No taxes or transaction costs
• Returns are normally distributed or investor’s utility
is a quadratic function in returns
• Investors can borrow or lend at the risk-free rate
• One period model
• The difficulties in selecting a proxy for the market
portfolio as a benchmark
• An alternative pricing theory with fewer assumptions was
developed: Arbitrage Pricing Theory (APT)
ARBITRAGE PRICING
THEORY
Definition
Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can
be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic
variables that capture systematic risk
Three Major Assumptions
• Capital markets are perfectly competitive
• Investors always prefer more wealth to less wealth with certainty
• The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or
indexes
In contrast to CAPM, APT doesn’t assume
• Normally distributed security returns
• Quadratic utility function
• A mean-variance efficient market portfolio
ARBITRAGE PRICING
THEORY
The APT Model
E(Ri)=λ0+ λ1bi1+ λ2bi2+…+ λkbik
where:
λ0= the expected return on an asset with zero systematic risk
λj= the risk premium related to the j th common risk factor
bij= the pricing relationship between the risk premium and the asset; that is,
how responsive asset i is to the j th common factor

The CAPM Model


• In CAPM, the relationship is as follows:
E(Ri)=RFR + βi[(E(RM-RFR)]

9-5
CAPM VS APT
A Comparison with CAPM
• Comparing CAPM and APT
CAPM APT
Form of Equation Linear Linear
Number of Risk Factors 1 K(≥ 1)
Factor Risk Premium [E(RM) – RFR] {λj}
Factor Risk Sensitivity βi {bij}
“Zero-Beta” Return RFR λ0

• Unlike CAPM that is a one-factor model, APT is a multifactor pricing model


• However, unlike CAPM that identifies the market portfolio return as the factor, APT model does not specifically
identify these risk factors in application
• These multiple factors include
 Inflation
 Growth in GNP
 Major political upheavals
 Changes in interest rates
USING APT – AN EXAMPLE
Selecting Risk Factors
• As discussed earlier, the primary challenge with using the APT in security valuation is identifying the risk
factors
• For this illustration, assume that there are two common factors
 First risk factor: Unanticipated changes in the rate of inflation
 Second risk factor: Unexpected changes in the growth rate of real GDP
Determining the Risk Premium
• λ1: The risk premium related to the first risk factor is 2 percent for every 1 percent change in the rate (λ1=0.02)

• λ2: The average risk premium related to the second risk factor is 3 percent for every 1 percent change in the rate of growth
(λ2=0.03)

• λ0: The rate of return on a zero-systematic risk asset (i.e., zero beta) is 4 percent (λ0=0.04)
USING APT
Determining the Sensitivities for Asset X and Asset Y
• bx1 = The response of asset x to changes in the inflation factor is 0.50 (bx1 0.50)
• bx2 = The response of asset x to changes in the GDP factor is 1.50 (bx2 1.50)
• by1 = The response of asset y to changes in the inflation factor is 2.00 (by1 2.00)
• by2 = The response of asset y to changes in the GDP factor is 1.75 (by2 1.75)

Estimating the Expected Return


• The APT Model
E ( R i )   0  1bi1   2 bi 2

= .04 + (.02)bi1 + (.03)bi2


• Asset X
E(Rx) = .04 + (.02)(0.50) + (.03)(1.50)
= .095 = 9.5%
• Asset Y
E(Ry) = .04 + (.02)(2.00) + (.03)(1.75)
= .1325 = 13.25%
SECURITY VALUATION WITH THE APT AN
EXAMPLES
Three stocks (A, B, C) and two common systematic risk factors have the following relationship (Assume λ0=0 )

E(RA)=(0.8) λ1 + (0.9) λ2

E(RB)=(-0.2) λ1 + (1.3) λ2

E(RC)=(1.8) λ1 + (0.5) λ2

If λ1=4% and λ2=5%, then it is easy to compute the expected returns for the stocks:

E(RA)=7.7%

E(RB)=5.7%

E(RC)=9.7%
Expected Prices One Year Later
• Assume that all three stocks are currently priced at $35 and do not pay a dividend
• Estimate the price

E(PA)=$35(1+7.7%)=$37.70

E(PB)=$35(1+5.7%)=$37.00

E(PC)=$35(1+9.7%)=$38.40
MULTIFACTOR MODELS & RISK
ESTIMATION
The Multifactor Model in Theory
• In a multifactor model, the investor chooses the exact number and identity of risk factors, while the
APT model doesn’t specify either of them
• The Equation
Rit = ai + [bi1F1t + bi2 F2t + . . . + biK FKt] + eit

where:
Fit=Period t return to the jth designated risk factor

Rit =Security i’s return that can be measured as either a nominal or excess return to

The Multifactor Model in Practice


• Macroeconomic-Based Risk Factor Models: Risk factors are viewed as macroeconomic in nature
• Microeconomic-Based Risk Factor Models: Risk factors are viewed at a microeconomic level by
focusing on relevant characteristics of the securities themselves,
• Extensions of Characteristic-Based Risk Factor Models

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