Reading 6: The Arbitrage Pricing Theory and Multifactor Models of Risk

and Return

After completing this reading, you should be able to:

Explain the arbitrage pricing theory (APT), describe its assumptions, and compare the

APT to the CAPM.

Describe the inputs (including factor betas) to a multifactor model and explain the

challenges of using multifactor models in hedging.

Calculate the expected return of an asset using a single-factor and a multifactor model.

Explain how to construct a portfolio to hedge exposure to multiple factors.

Describe and apply the Fama-French three-factor model in estimating asset returns.

In the previous reading, we discussed the Capital Asset Pricing Model (CAPM). CAPM is a single-

factor model that gives the expected return of a portfolio as a linear function of the markets’ risk

premium above the risk-free rate, where beta is the gradient of the line.

On the other hand, the Arbitrage Pricing Model (APT) uses the same analogy as CAPM, but it

includes multiple economic factors.

The Arbitrage Pricing Theory

According to APT, multiple factors (such as indices on stocks and bonds) can be used to explain

the expected rate of return on a risky asset. APT has three common assumptions.

Assumptions of the APT model:

1. The returns from the assets can be explained using systemic factors.

2. No arbitrage opportunities exist in a well-diversified portfolio. (Arbitrage refers to the

action of buying an asset in the cheaper market and simultaneously selling that asset in

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 the more expensive market to make a risk-free profit.)

3. By using diversification, the specific risks can be eliminated from the portfolios by the

investors.

According to APT, return on given security i is given by:

Ri = E(Ri) + βi1 [I1 − E(I1 )] + ⋯ + βi K [IK − E(IK )] + ei

Where

R i: rate of return on security i (i = 1, 2, …, N)

E(R i ): the expected return of security i.

IK − E(IK ): Surprise factor (the difference between the observed and expected values in factor k)

βiK : measure the effect of changes in a factor I_k on the rate of return of security i

ei : noise factor also called idiosyncratic factor

The APT was put to trial by Roll and Ross (1980) and Chen, Roll, and Ross (1986) while

determining the factors that explained the average returns on traded stocks on New York

Securities Exchange (NYSE).

According to Roll, a well-diversified portfolio are volatile, and that the volatility of a long

portfolio is equivalent to half of the average volatility of its constituent assets. Therefore, he

concluded that systematic risk drivers limit the impact of diversification within the asset groups.

According to Ross (1976), assuming that there is no arbitrage opportunity, the expected return

on a well-diversified is given by:

E(R P ) = E(RZ ) + βP 1 [E(I1 ) − E(RZ )] + ⋯ + βP K [E(IK ) − (R Z)]

where

E(R P ): Expected return on a well-diversified portfolio

βPK : Factor loading for portfolio relative of factor k

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E(R Z ): Expected rate of return on a portfolio with zero betas (such as risk-free rate of return)

E(IK ) − E(RZ ): Risk premium relative to factor k

Moreover, Roll realized that a portfolio that has been adequately diversified possesses a high

correlation when it is drawn from a similar asset class and less correlation when diversification

occurs across multiple asset groups.

Example: Calculating Expected Return under APT

The following data exists for asset A:

Risk-free rate = 3%,

GDP factor beta = 0.40,

Consumer sentiment factor beta = 0.20,

GDP risk premium = 2%,

Consumer sentiment risk premium = 1%

Calculate the expected return for Asset A using a 2-factor APT model.

E (RA ) = 0.03 + 0.4 (0.02) + 0.2 (0.01) = 0.04 = 4%

Note: Both CAPM and APT describe equilibrium expected returns for assets. CAPM can be

considered a special case of the APT in which there is only one risk factor – the market factor.

Many investors prefer APT to CAPM since APT is an improved version of CAPM. This is because

CAPM is a one-factor model (only the market index is used to calculate the expected return of

any security). At the same time, the APT is a multifactor model where numerous indices are used

to explain the variation of the expected rate of return of any security.

Multifactor Models

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A multifactor model is a financial model that employs multiple factors in its calculations to

explain asset prices. These models introduce uncertainty stemming from multiple sources.

CAPM, on the other hand, limits risk to one source – covariance with the market portfolio.

Multifactor models can be used to calculate the required rate of return for portfolios as well as

individual stocks.

CAPM uses just one factor to determine the required return – the market factor. However,

the market factor can be split up even further into different macroeconomic factors. These may

include inflation, interest rates, business cycle uncertainty, etc.

A factor can be defined as a variable that explains the expected return of an asset.

A factor-beta is a measure of the sensitivity of a given asset to a specific factor. The bigger the

factor, the more sensitive the asset is to that factor.

A multifactor appears as follows:

Ri = E (R i) + βi1 F1 + βi 2 F2 + ⋯ + βik Fk + ei

Where:

R i=rate of return on stock i

E (R i) =expected return on stock i

βik =sensitivity of the stock's return to a one-unit change in factor k

Fk =Macroeconomic factor k

ei =the firm-specific return/portion of the stock's return unexplained by macro factors

The expected value of the firm-specific return is always zero.

The Expected Return of An Asset Using the Single-factor

The single-factor model assumes there’s just one macroeconomic factor, and appears as follows:

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 Ri = E (R i) + βi F + ei

E (R i) is the expected return on stock i . In case the macroeconomic factor has a value of zero in

any particular period, then the return on the security will equal its initially expected return E (R i)

plus the effects of firm-specific events.

Example of a Single-factor Model

Assume the common stock of Blue Ray Limited (BRL) is examined with a single-factor model,

using unexpected percent changes in GDP as the single factor. Assume the following data is

provided:

Expected return for BRL = 10%

GDP factor-beta = 1.50

Expected GDP growth = 4%

Compute the required rate of return on BRL stock, assuming there is no new information

regarding firm-specific events.

Solution

We know that:

Ri = E (R i) + βi F + ei

= 10% + 1.5 × 4%

= 16%

The Expected Return of an Asset Using the Multi-factor Model

Example of a Multi-factor Model

Assume the common stock of BRL is examined using a multifactor model, based on two factors:

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unexpected percent change in GDP and unexpected percent change in interest rates. Assume the

following data is provided:

Expected return for BRL = 10%

GDP factor beta = 1.50

Interest rate factor beta = 2.0

Expected growth in GDP = 2%

Expected growth in interest rates = 1%

Compute the required rate of return on BRL stock, assuming there is no new information

regarding firm-specific events.

Ri = E (Ri ) + βi1 F1 + βi2 F2

= 10% + 1.5 × 2% + 2.0 × 1%

= 15%

Hedging Exposures to Multiple Factors

The specific risks (idiosyncratic risks) can be removed by diversification, but the factor betas

(systematic risk) can only be removed by hedging strategy. Each factor can be regarded as

fundamental security and can, therefore, be utilized to hedge the same factor relative to given

security.

Consider an investor who manages a portfolio with the following factor betas:

GDP beta = 0.4

Consumer sentiment beta = 0.20

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Case 1:

Assume the investor wishes to hedge away GDP factor risk, yet maintain the 0.20 exposure to

consumer sentiment. How would they achieve this?

The investor should combine the original portfolio with a 40% short position in the GDP factor

portfolio. The GDP factor-beta on the 40% short position in the GDP factor portfolio equals -0.40,

which perfectly offsets the 0.40 GDP factor-beta on the original portfolio.

Case 2:

Assume the investor might want to hedge away consumer sentiment (CS) factor risk, yet

maintain the 0.40 exposure to GDP. How would they achieve this?

The investor should combine the original portfolio with a 20% short position in the consumer

sentiment factor portfolio. The CS factor-beta on the 20% short position in the GDP factor

portfolio equals -0.20, which perfectly offsets the 0.20 GDP factor-beta on the original portfolio.

Case 3:

Assume the investor wants to hedge away both factor risks. How would they achieve this?

The investor would have to form a portfolio that’s 40% invested in the GDP factor portfolio, 20%

in the CS factor portfolio, and 40% in the risk-free asset (note that total = 100%). Let us refer to

this portfolio as portfolio H.

Portfolio H can be used to hedge away all the risk factors of the original portfolio. That would

involve combining the original portfolio with a short position in portfolio H. The original portfolio

betas (0.4 and 0.2) would be perfectly offset by the short position in portfolio H, the hedge

portfolio.

The Fama-French Three-Factor Model

One widely used multifactor model that has been developed in recent times is the Fama and

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French three-factor model. A major weakness of the APT model is that it is silent on the issue of

the relevant risk factors for use. The FF three-factor model puts three factors forward:

Size of firms

Book-to-market values

Excess return on the market

The firm size factor, also known as SMB (small minus big) is equal to the difference in returns

between portfolios of small and big firms (R s − Rb ).

The book-to-market value factor, also known as HML (high minus low) is equal to the difference

in returns between portfolios of high and low book-to-market firms (R H − RL ) .

Note: book-to-market value is book value per share divided by the stock price.

Fama and French put forth the argument that returns are higher on small versus big firms as

well as on high versus low book-to-market firms. This argument has indeed been validated

through historical analysis. Fama and French contend that small firms are inherently riskier than

big firms, and high book-to-market firms are inherently riskier than low book-to-market firms.

The equation for the Fama-French three-factor model is:

E(RP ) − r = βP M [E(R M ) − r] + βP , SMB E(S MB) + βP ,H ML E(HML)

Where,

E(R P ): is the expected return on portfolio P

r: risk-free interest rate;

E(R M − r), E(SMB) and E(HML): expected premiums;

βPM , βP ,SM B, b P ,H ML : the coefficients for the time-series regression:

R P − r = aP + βPM (R M − r) + βP ,SMB SMB + βP ,HM L H ML + ϵ P

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The intercept term, α p , equals the abnormal performance of the asset after controlling for its

exposure to the market, firm size, and book-to-market factors. As long as the market is in

equilibrium, the intercept should be equal to zero, assuming the three factors adequately capture

all systematic risks. ϵ i represents random error.

Exam tip: SMB is a hedging strategy – long small firms, short big firms. HML is also a hedging

strategy – long high book-to-market firms, short, low book-to-market firms.

Fama and French expanded their model in 2015 by proposing two factors:

Robust Minus Weak (RMW). RMW is the difference between the return of firms with

high (robust) and weak (low) operating profitability.

Conservative Minus Aggressive (CMA): the difference between the returns of the firms

that conservatively invest and those with aggressive kind of investment.

Example: Calculating the Expected Return of a Portfolio Based on the

A Firm’s financial analyst believes the Fama-French dependencies are given in the table below.

Value
Beta 0.3
SMB 1.25
HML -0.7

Solution The firm earns an extra 4% yearly due to competitive advantage. Moreover, the firm

earns a 15% return on equities, an SMB of 2.5%, and HML of 0% and a risk-free rate of 2%.

What is the expected return of the firm?

According to the Fama-French Three-Factor Model the expected return is given by:

R P − r = aP + βPM (R M − r) + βP ,SM BSMB + βP ,H ML H ML

RP − 2% = 4% + 0.30(15% − 2%) + 2.5% × 1.25 − 0.70 × 0% = 13.03%

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Question

Suzy Ye is a junior equity research analyst at a research firm based in South Korea.

For the first time, she is using the multifactor model to compute the return of Wong

Kong Corp (WK). She has compiled the following data for the computation of the

return:

Wong Kong's expected return: 7%

Expected GDP growth: 4.5%

Expected Inflation: 2.5%

GDP factor-beta: 1.5

Inflation factor-beta: 2

Risk-free rate: 2%

Suppose the actual GDP growth and actual inflation of South Korea are 3% and 2.9%,

respectively, then which of the following is an accurate estimate of the return?

A. 7.55%

B. 10.05%

C. 5.55%

D. 18.75%

The correct answer is C.

A multifactor model (2-factor model in the given question) only includes the expected

return of the stock, macroeconomic factor and the factor-beta, and firm-specific risk,

which in this case is zero.

RWK = E(RWK) + βGDPFGDP + βIFI

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= 0.07 + 1.5(0.03 - 0.045) + 2(0.029 - 0.025)

= 0.07 - 0.0225 + 0.008 = 5.55%

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