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Topic 5

The document discusses the Arbitrage Pricing Theory (APT) as an alternative to the Capital Asset Pricing Model (CAPM). Some key points: - APT relaxes some assumptions of CAPM, such as normally distributed returns and a single-factor market model. APT instead uses a multi-factor model with an unspecified number of systematic risk factors. - Identifying the specific risk factors is challenging in applying APT. Examples given are inflation, GDP growth, and interest rates. - An example is shown estimating expected returns for two assets based on their sensitivities to two factors: inflation and GDP growth. - Arbitrage opportunities can exist if an asset is

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17 views19 pages

Topic 5

The document discusses the Arbitrage Pricing Theory (APT) as an alternative to the Capital Asset Pricing Model (CAPM). Some key points: - APT relaxes some assumptions of CAPM, such as normally distributed returns and a single-factor market model. APT instead uses a multi-factor model with an unspecified number of systematic risk factors. - Identifying the specific risk factors is challenging in applying APT. Examples given are inflation, GDP growth, and interest rates. - An example is shown estimating expected returns for two assets based on their sensitivities to two factors: inflation and GDP growth. - Arbitrage opportunities can exist if an asset is

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andy033003
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Disclaimer: All teaching and

learning materials, including slides,


handouts, videos, assessments etc.,
are the properties of Taylor’s
University and are meant solely for
the purpose of teaching and
learning activities, which are held
only for Taylor’s University’s
registered students. You are not
permitted to publish or share the
materials without the lecturer’s
consent. It is important to note that
TIMeS is the official e-learning
platform for Taylor’s University
students.
▪ CAPM is criticized because of
▪ The many unrealistic assumptions
▪ 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)
▪ 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

9-4
▪ 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
9-5
▪ A Comparison with CAPM
▪ In CAPM, the relationship is as follows:

E(Ri)=Rf + βi[(E(RM-Rf)]
Comparing CAPM and APT (Exhibit 9.1)
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 Rf λ0

9-6
More Discussions on APT
▪ 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

9-7
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: Un-anticipated changes in the rate of
inflation
▪ Second risk factor: Unexpected changes in the growth rate
of real GDP

9-8
Estimating the Expected Return
▪ The APT Model
E ( Ri ) = 0 + 1bi1 + 2bi 2
= 0.04 + (0.02)bi1 + (0.03)bi2
▪ Asset X
E(Rx) = 0.04 + (0.02)(0.50) + (0.03)(1.50)
= 0.095 = 9.5%
▪ Asset Y

E(Ry) = 0.04 + (0.02)(2.00) + (0.03)(1.75)


= 0.1325 = 13.25%

9-9
▪ Determining the Risk Premium
▪ λ1: The risk premium related to the first risk factor is 2% for every 1%
change in the rate (λ1=0.02)
▪ λ2: The average risk premium related to the second risk factor is 3%
for every 1% 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% (λ0=0.04)

9-10
▪ 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)

9-11
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)=(0.8)(4%) + (0.9)(5%) =7.7%
E(RB)=(-0.2)(4%) + (1.3)(5%)=5.7%
E(RC)=(1.8)(4) + (0.5)(5) =9.7%

9-12
Previously
Assume P0 = $35 calculated 1+E(R)

E(PA) = $35(1.077)= $37.70 Over-valued ($37.7 vs $37.2)


E(PB) = $35 (1.057) = $37.00 Under-valued ($37 vs $37.8)

E(PC) = $35 (1.097) = $38.40 Under-valued ($38.4 vs


$38.5)

*You believe the actual prices of stocks A, B,


and C will be $37.20, $37.80, and $38.50 one
year later
**Short sell stock A; Long Stock B & C
9-13
▪ Arbitrage Opportunity
▪ If one “knows” actual future prices for these stocks
are different from those previously estimated, then
these stocks are either undervalued or overvalued
▪ Arbitrage trading (buying undervalued stocks and
short overvalued stocks) will continues until
arbitrage opportunity disappears

Riskless arbitrage is to assemble portfolio with


1) No wealth invested ;
2) zero risk exposure;
3) Positive actual portfolio return

9-14
▪ Since only stock A is overvalued, short sell it, and buy
stock B and C (undervalued)
▪ Consider the proportions: WA= -1.0; WB = 0.5; WC=0.5

1)Net initial investment =


Short 2 shares of A ($35x 2 = +$70)
Purchase 1 share of B (($35 x1=-$35)
Purchase 1 share of C ($35 x1=-$35)
Net investment = 0 (*meet requirement no. 1)

9-15
2) Net exposure to risk factors:
Factor 1 Factor 2
(WA)(b1)
(WA)(b1)

Weighted exposure from stock A (-1.0)(0.8) (-


1.0)(0.9)
Weighted exposure from stock B (0.5)(-0.2)
(0.5)(1.3)
Weighted exposure from stock C (0.5)(1.8)
(0.5)(0.5)
(*meet requirement no. 2)
Net exposure 0 0
9-16
3) Net profit=
Short 2 stocks A = 2($35) – 2($37.2)=-$4.40
Buy 1 stock B = 1($37.80) - 1($35)=$2.80
Buy 1 stock C =1 ($38.5) – 1($35) = $3.5
$1.90

(*meet requirement no. 3)


POSITIVE PROFIT

9-17
▪ Roll-Ross Study (1980)
▪ The methodology used in the study is as follows
▪ Estimate the expected returns and the factor
coefficients from time-series data on
individual asset returns
▪ Use these estimates to test the basic cross-
sectional pricing conclusion implied by the
APT
▪ The authors concluded that the evidence
generally supported the APT, but acknowledged
that their tests were not conclusive

9-18
9-19

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