SAPM Module – 3

Multifactor Model
and
Arbitrage Pricing Theory
 Single Factor Model
Ω Returns on a security come from two sources

ő Common macro-economic factor

ő Firm specific events

Ω Possible common macro-economic factors

ő Gross Domestic Product Growth

ő Interest Rates

ő Inflation etc.
 Single Factor Model Equation
ri  E ( ri )   i F  e i

ri = Return for security i

i = Factor sensitivity or factor loading or factor beta

F = Surprise in macro-economic factor

(F could be positive, negative or zero)

ei = Firm specific events

 Problems With Single Factor Model
Ω Takes into consideration the effect of single

macroeconomic factor

ő Often there exists more than one macroeconomic factors

ő Like unexpected changes in GDP, Inflation, interest rates etc.

 Problems With Single Index Model
Ω Single Index model assumes market return as proxy for all
economic factors
Ω Sometime it is more appropriate to focus on ultimate source
of risk
Ω Index Model Assume that stocks have same sensitivity to all
macro economic factor
ő In fact stocks have different sensitivity to different factors

ő Stocks have different betas for different factors (Factor betas)

 Multifactor Models
Ω Uses more than one factor in addition to market return
ő Examples include gross domestic product, expected
inflation, interest rates etc
ő Measures stock’s sensitivity to different factors
• Estimate a beta or factor loading for each factor using
multiple regression
ő Helps to measure our risk exposure to various
macroeconomic factors, and construct a portfolio to
hedge those risks
 Multifactor Model Equation
Two Factor Model
ri = E(ri) + i GDP GDP + iIR IR + ei

ri = Return for security i

i = Factor sensitivity for GDP
GDP
i
IR = Factor sensitivity for Interest Rate
ei = Firm specific events
 Multifactor Model
Ω Example:
r 0.2  2.2GDP  0.6 IR  e
Ω Here expected rate of return based on currently available
information is 20%
Ω GDP refer to unanticipated change in expected GDP rate
Ω IR refer to unanticipated change in expected interest rates
Ω GDP beta is 2.2 and interest rate beta is 0.6
Ω For every percentage point increase in GDP beyond current
expectations, return on stock will increase by 2.2%
Ω For every percentage point change in IR beyond current
expectations, return on stock will change by 0.6%
 Multifactor SML
r E (ri )   iGDP GDP   iIR IR  ei

E (ri ) rf   i (rm  rf )

Ω Problems with SML

ő The benchmark risk premium is given by the market
portfolio
ő Do not recognize the risk premium of individual factors
ő Do not recognize the stock specific sensitivity to
macroeconomic event
 Multifactor SML Models
E(r) = rf +iGDPRPGDP + IRi RPIR

i GDP = Factor sensitivity for GDP

RPGDP = Risk premium associated with one unit of

i GDP exposure
IR = Factor sensitivity for Interest Rate
RPIR = Risk premium associated with one unit of
Interest Rate exposure
 Example – 1
Ω Jet airways has GDP beta of 2.2 and interest rate beta
of 0.6.
Ω Risk premium for one unit of exposure to GDP risk is
6% and risk premium for one unit of exposure to
interest rate risk is 3%
Ω Risk free rate is 5%
Ω Find out the expected return for Jet by using
multifactor SML
E(r) = rf +i GDPRPGDP + iIRRPIR

E (ri ) 5  2.2 6  0.6 3 20%

 Arbitrage Pricing Theory
Ω Arbitrage means buying an asset at low price form
one market and selling the same asset at high price
in other market
Ω Arbitrage opportunity exist only when law of one
price is violated
Ω Never last too long
 Arbitrage Pricing Theory
Ω Stephen Ross developed the arbitrage pricing
theory
Ω Just like CAPM, APT predicts a SML linking expected
return to risk
Ω Relies on three key propositions
ő Securities returns can be described by a factor model
ő There are sufficient securities to diversify away the
unsystematic risk
ő Well functioning security markets do not allow for the
persistence of arbitrage opportunities
 Arbitrage Pricing Theory and Portfolio
Ω Arbitrage arises if an investor can construct a zero
investment portfolio with a sure profit
Ω Since no investment is required, an investor can create
large positions to secure large levels of profit
Ω In efficient markets, profitable arbitrage opportunities
will quickly disappear
ő Law of one price

ő No arbitrage argument
 APT & Well-Diversified Portfolios
rP = E (rP) + PF + eP

F = some macro factor

Ω For a well-diversified portfolio:
ő Unsystematic risk approaches zero

ő As expected value of (eP ) is zero, and its variance also is

effectively zero, for a well diversified portfolio

rP = E (rP) + PF
 Figure 10.1 Returns as a Function of the
Systematic Factor

 1  1

Diversified Portfolio Single Stock

Return on stock B is scattered because it is exposed to both

systematic as well as unsystematic risk
 Figure 10.2 Returns as a Function of the
Systematic Factor: An Arbitrage Opportunity

 A 1
 B 1

Well diversified portfolios with equal betas must have the same
expected return or arbitrage opportunities exist
Figure 10.3 An Arbitrage Opportunity

Risk premium is proportional to portfolio beta in well

diversified portfolio
 APT and CAPM Compared
Ω Similarities
ő Like CAPM model APT also gives benchmark for rates of
return that can be used in security valuation, investment
evaluation etc.
ő Like CAPM model APT also highlights distinction between
diversifiable and non diversifiable risks
 APT and CAPM Compared
Ω Differences
ő APT applies to well diversified portfolios and not necessarily
to individual stocks
ő With APT it is possible for some individual stocks to be
mispriced - not lie on the SML
ő APT is more general in that it gets to an expected return and
beta relationship without the assumption of the market
portfolio
 Multifactor APT
Ω Use of more than a single factor

Ω Requires formation of factors

Ω What factors?

ő Factors that are important to performance of the

general economy

Ω A two factor APT model

ri  E ( ri )   i 1 F 1   i 2 F 2  e i
 Example - 2
Ω Suppose that two factors have indentified for the
US economy: the growth rate of industrial
production IP and inflation rate IR.
Ω IP is expected to be 3% and IR 5%. A stock with
beta of 1 on IP and 0.5 on IR currently is expected
to provide a rate of return of 12%.
Ω If industrial production actually grows by 5% while
the inflation rate turn out to be 8% what is your
revised estimate of expected rate of return on stock
 Example – 3
Ω Suppose that there are two independent economic
factors F1 and F2. The risk free rate is 6%. The
following are the well diversified portfolios.
Portfolio Beta F1 Beta F2 Expected Return
A 1.5 2 31
B 2.2 -0.2 27

Ω What are the expected return beta relationship in

this economy?
 Example – 3
Ω Risk premium for F1 and F2
E rP  rf   F 1 RPF 1   F 2 RPF 2

Ω Solving these two equations

Ω Thus the expected return-beta relationship is:

 Example – 4
Ω Consider the following data for one factor
economy. All the portfolios are well diversified.
Portfolio E(r) Beta
A 12% 1.2
F 6% 0

Ω Suppose another portfolio, portfolio E is well

diversified with beta of 0.6 and expected return of
8%.
Ω Would an arbitrage opportunity exist? If so, what
would be the arbitrage strategy?
 Example – 4
Ω Would an arbitrage opportunity exist?
ő Ratio of risk premium to beta
12  6
For Portfolio – A = 5
1.2

For Portfolio – E = 8  6 3.33

0.6
This implies that an arbitrage opportunity exists.
 Example – 4
Ω Create a Portfolio ‘G’ by combining Portfolio A and Portfolio
F in equal weights.
Ω The expected return and beta for Portfolio ‘G’ are then:

Ω Comparing Portfolio G to Portfolio E, G has the same beta

and higher return.
Ω Therefore an arbitrage opportunity exists by buying
Portfolio G and selling an equal amount of Portfolio E
Ω The profit for this arbitrage will be:
 Example – 5
Ω Consider the following multifactor APT model of a security
returns for a particular stock
Factor Factor Beta Factor Risk Premium
Inflation 1.2 6%
Industrial Production 0.5 8%
Oil Prices 0.3 3%

A. If treasury bills currently offers 6% yield, find the expected rate

of return on this stock, if the market views the stock as fairly
priced
B. Suppose that market expected the value for the three macro
factors given in column 1 below but that actual values turn out
as given in column 2. Calculate revised expectation for the rate
of return on stock.
 Example – 5

Factor Expected rate of Actual rate of

change change

Inflation 5% 4%
Industrial Production 3% 6%
Oil Prices 2% 0%
 Example – 5
Ω Expected rate of return on the stock

Ω Unexpected return from macro factors