CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND

ADDITIONAL RISK FACTORS

The CAPM is one approach to thinking about competitive financial markets. An alternative approach discussed at length in Chapter 10 is arbitrage pricing theory (APT). This set of notes
provides some context for how APT is different from CAPM, but also how APT arrives at the same
conclusion: there is a risk-return tradeoff governed by the security market line.
These approaches (CAPM and APT) give two different theories about how competition drives
abnormal investor profits to zero. Technically, theyre founded on different sets of assumptions,
which is nice. The result that the risk-return tradeoff embedded in the SML can be justified on
two different grounds lends some robustness to the result. Moreover, both models of investor
competition feed into a notion of market efficiency the efficient market hypothesis which well
discuss here.
Finally, to make these models of investor competition more realistic, we conclude these notes by
discussing multiple risk factors or models that allow each securitys risk premium to depend on
a number of risk factors, for which each source of risk is priced.
1. A RBITRAGE AND W ELL -D IVERSIFIED P ORTFOLIOS
The APT (developed by Stephen A. Ross in 1976) relies on quite different assumptions than the
CAPM. Moreover, these assumptions are less restrictive than the CAPM assumptions, which may
make APT somewhat more reasonable. Namely, we maintain three assumptions.
(1) Excess returns are described by a factor model (e.g., the single index model in the case of
one factor).
(2) There are enough financial assets to allow the investor to diversify away firm-specific risk
(i.e., (eP ) can be made small).
(3) The market does not allow for arbitrage opportunities to persist.
This last point deserves some definition, and some explanation. An arbitrage opportunity is an
opportunity to make riskless profit, which is accomplished by simultaneously buying and selling
multiple financial securities.
For example, an arbitrage opportunity would exist if the same financial asset sells for different prices on two different exchanges. If prices are different on the two exchanges, an
arbitrageur can make riskless profit by short selling the security with the high price at the
same time as buying the security with the low price.
This is different than the seeking-alpha based rationalization of CAPM. Theoretically, if the arbitrage opportunity persists, an arbitrageur would want to take an infinite position in the mispriced
stock.
1

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

1.1. Arbitrage Pricing. Sticking with a single-index model, we can write the portfolio excess
returns as:
R P = P + P R M + e P
just as we did in Chapter 8. After writing down this portfolio single-index equation (a single-factor
model), we lean hard on the second APT assumption that it is possible to construct a portfolio
with residual variance 2 (e p ) 0. In this case, we might as well ignore eP because it hardly
contributes to the variance of the portfolio excess returns. Mathematically, we can write this as:
RP P + P RM
Already, we can see that the only source of risk here is the P RM term. We could thus construct a
tracking portfolio that earn returns RT = P RM , and short it to completely eliminate risk: Rarb =
RP RT = P , yet still have some excess return. The nearby box shows how to get the portfolio
weights to accomplish this.
Now, form a portfolio of RM with RP . Before doing so, notice that neither the market index,
nor the well-diversified portfolio have any idiosyncratic risk. Is it possible to form a portfolio
without (even) systematic risk? Note that we can construct a portfolio Z with weights wP on the
well-diversified portfolio P and 1 wP on the market index M. We calculate the returns with the
portfolio forming equation:
RZ = wP RP + (1 wP ) RM
Recall (from Chapter 8) that the Z of this composite portfolio can be obtained by plugging the
betas of the component assets into the portfolio forming equation, as in:
Z = wP P + (1 wP ) M
and remember that the market has beta of 1. To rephrase the question in bold, is it possible for
Z = 0? Yes! Lets just set Z = 0 and solve for the weight wP that does this:
Z = 0

wP

wP P + (1 wP ) 1
1
1 P

Given that Z was set to be zero,

E [RZ ] = Z + Z E [RM ]
= Z
and Z = wP P + (1 wP ) M = wP P because the alpha for the market is 0. Putting all this
together,
1
P
E [RZ ] =
1 P
The box develops a portfolio that is riskless (well-diversified means no idiosyncratic risk, and
P
Z = 0 means no systematic risk), but it has return of 1
. As long as P 6= 1, you can profit from
P
P
P
this. If 1P > 0, the arbitrageur should buy Z. If 1P < 0 , the arbitageur should short sell Z.

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

Moreover, because the arbitrage involves zero net investment (buying and selling at the same time),
the arbitrageur can take unbelieveably large positions in Z. This extreme trading behavior forces
prices such that P = 0.

1.2. Comparing the CAPM, the APT, and Treynor Black (Chapter 8 Index Model Technique). With P = 0, we obtain the APT risk-return formula for the well-diversified portfolio:
E [RP ] = P E [RM ]

This is the analogue of the security market line from CAPM. This points to a number of distinctions
between CAPM and APT.
The fact that the APT only delivers an analogue of the security market line for welldiversified portfolios is a limitation of the APT. In contrast, CAPM delivers a SML for
every security that is freely-available to trade.
This stronger conclusion is the result of a stronger assumption (to the point of lack of
realism). The CAPM requires that every investor is an identical mean-variance optimizer
(in the sense of Chapter 7). On the other hand, the APT only requires a small number
of arbitrageurs to seek arbitrage opportunities. If were willing to live with the weaker
conclusion that only well-diversified portfolios exhibit a mean-beta relationship the
APT can be a quite attractive alternative to the CAPM.
The book makes an argument for APT being unbiased (albeit inexact) for less well-diversified
portfolios. This is worth a read, but it is mostly academic. Check out the discussion on
page 335.
Finally, how does the Chapter 8 Index Model Algorithm (called the Treynor-Black Procedure) relate to the APT? Its actually pretty close, and better in a lot of respects. The
T-B Procedure implies that we should invest in each asset in proportion to pseudo weights
i
. Note that as the residual variance decreases 2 (ei ) 0, the pseudo weight become
2 (ei )
large (very large; i.e., infinite). In the extreme, as the asset becomes well diversified in
the sense of less residual risk, the recommendation of the T-B procedure becomes the same
as the APT. On this basis, the T-B procedure is well founded in addition to being a slick
way to operationalize valuable security and macro analysis.

2. M ARKET E FFICIENCY

The description of market efficiency here is rather stylized, and somewhat unbalanced. Namely,
well leave the discussion of market anomalies to after the exam. For now, suffice it to say that
market anomalies are anomalous for a reason. Markets are remarkably competitive, which does
much to drive the pricing of assets.

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

F IGURE 1. Midday Price Adjustments

2.1. What does an Efficient Market Look Like? Security prices are difficult to predict, and
competition make this so. The book has several examples of this, but the most notable one is a
study of how quickly security prices react to midday news mentions. According to the figure in
BKM, the price adjusts fully to the news within 5 to 10 minutes of a midday mention on CNBC
(Figure 1 reproduces this figure here in the notes). That is rapid adjustment and incorporation of
new information into market prices, and because the information was not known before its release,
there was no way to actionably trade on the information prior to traders new orders incorporating
the information into the price.
Rapid incorporation of relevant information into security prices (through trading on that information) is the hallmark of an efficient market. Efficient is really an awkward word for this idea.
When we call a market efficient, were not making a statement about it being good (even though
the word sounds like a good word). Rather, we mean that information is efficiently incorporated
into security prices. On this basis, maybe we should call it informationally-efficient markets, but
we are stuck with the terminology that everyone knows and uses.

2.2. Forms of Market Efficiency. Broadly, the efficient market hypothesis (EMH) is that current stock prices reflect all available information about the future values of assets. This statement
does not articulate what information is available, and thus, is incorporated into the current stock
prices, and once we go down the path of specifyin what information is available, there are three
different forms of the EMH.
Weak-Form EMH. Current stock prices reflect all information that can be obtained publicly from past prices, trading volume, etc. Because current price reflect all of this information, examining and analyzing trends is hopeless (according to the weak-form EMH).

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

Semi-Strong Form EMH. Current stock prices reflect all available information regarding
the prospects of the firm (e.g., new rivals entry plans, product announcements, past earnings
announcements, patents held, balance sheet information, etc.). Under this form of the
EMH, analyzing balance sheet information (also, industry competition analysis based on
available information) to gain an advantage is also hopeless.
Strong-Form EMH. All information relevant to the firm is incorporated into the stocks
price. This includes information available only to company insiders. Especially given
that insider trading is actively monitored and procecuted by the SEC, this is a particularly
unreasonable form of the EMH.
Regardless of which form of the EMH you find most (least) plausible, the EMH has practical
insight. If market opportunities disappear quickly due to vicious competition for trading profits,
consistently generating trading profits is hard work. At minimum, youll have to be better at
producing and exploiting information than the next guy, and youve got lots of competitors.
Buried in all of this pessimism about generating trading profits, there is a nugget of hope. All of
these efficient market hypotheses and theories of competition rely upon vicious competition among
investors. In equilibrium, someone has to do the research to do the trading to make the markets
informationally efficient, and for that research to be incentive-compatible, there need to be enough
trading profits to make it worth it. The bottom line is that trading profits are possible (indeed,
necessary) within the efficient markets framework.
Thus is the paradox of efficient markets. Efficient markets require the allure of trading profits
to incentivize many competitive analysts to uncover and exploit information about stock prices
quickly. Yet, efficient markets imply that these trading profits are scarce in equilibrium. Well
return to critiques of the EMH after the exam.
3. A DDITIONAL R ISK FACTORS
Both the APT and the T-B procedure are deficient in an important respect respect. These models
assume that there are only two types of risk that affect each securitys excess returns: aggregate/market risk and firm-specific risk.
Ri = i + i RM + ei
Importantly, this assumption means that every

firms firm-specific risk term ei is unrelated to other
firms idiosyncratic risk (in math, Cov ei , e j = 0).
3.1. Extending the Single Index Model. Just thinking about industries, this cannot be true.
Namely, AAPL and MSFT are stocks of technology companies that produce and market tablets.
Tablet-specific news will tend to make the firm-specific component of excess returns for AAPL
and MSFT be correlated. More generally, such is the case for companies that share industries, suppliers, customers, sensitivity to transportion, etc. On these grounds, we might consider a multiple
index model or multifactor model or multiple factor model (for example):
Ri = i + i,M RM + i, f insector R f insector + i,comm Rcomm + ei
where Rdistress is an index of financial sector firms, Rsize is an index of commodities. Just given this
example, it is not hard to think about how different compaies would have different exposure to the

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

financial sector, as well as to commodities, and that these exposures might affect a broad swath of
firms in the economy, not just a single firm.
Importantly, this multiple-index model is a natural extension of the single index model, and within
the active portfolio, the Treynor-Black Procedure works exactly the same, conditional on estimating i , (ei ) from a multiple regression.
The resulting multiple-index security market line is just the expectation of the multiple index
model with the i zeroed out (either by an extended CAPM argument, or an extended APT
argument).


E [Ri ] = i,M E [RM ] + i, f insector E R f insector + i,comm E [Rcomm ]
More generally, for k indexes, the SML is
k

E [Ri ] =

i, j E

 
Rj

j=1

3.2. Advantages and Disadvantages of Multifactor Models.

Advantage: Realism.
Relative to the single-index model, multifactor models that allow for a number of
additional sources of risk that are neither market wide, nor firm specific provide a
much more realistic depiction of risk.
Unlike the single-index model, excess returns of different securities in a multifactor
model are not just correlated through their relationship through the market. For example, dependence on some technology-specific factor can explain the relationship of
AAPL to MSFT. The multifactor model accounts for this kind of correlation while the
single-index model assumes such relationships away.
Advantage: Forming Portfolios that are Free of Factor Risk.
The multifactor model soaks up variation in a securitys excess returns that are due to
the relationship of excess returns to these additional risk factors using terms i, f ac R f ac
terms. This changes the meaning of the resulting estimate of i . Instead of being excess return that is independent of market risk, i is excess return that is not attributable
to any of the risk factors in the multifactor model.
Given estimates of i and (ei ) for each security in the active investment universe,
the Treynor-Black pseudo weight procedure can be applied directly within the active
portfolio, just invest in proportion to the pseduo weight w pseudo = 2(ei ) .
i
Then, deciding how much to put into active versus passive is trickier. Two options are natural, but more complicated methods undoubtedly exist.
(1) Use a Tracking Portfolio to eliminate factor risk. Namely, construct a
portfolio T that has excess returns of
RT i,M RM + i,2 R2 + ... + i,J RJ
Then, short the tracking portfolio while holding the active portfolio from
the Treynor-Black procedure. RP = RA RT = A + eA . For a sufficiently
well-diversified portfolio, eA is small and the fruits of this technique, A ,

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

are realized in trading profits. The great thing about this technique is that
returns are not at all sensitive to factor risk.
(2) Proceed with Treynor-Black, but ignore the other factors in deciding
active versus passive. This is a bit of a cheat, but it is not so bad. The
advantage of the factor model here is that the assets that look attractive
in the active portfolio do not look attractive because they load on factor
risk. This is because the i and (ei ), which form the basis for active
portfolio weights, are independent of factor risk. A subtle implication of
the multifactor model is that the i,M is also obtained while holding the
other factors constant. Thus, the active-versus-passive decision is relatively
uncontaminated by these other factors.
(3) Other methods are possible. Namely, it may be sensible to form a portfolio of the factors, and to think carefully about how to invest actively relative
to that portfolio. This seems most sophisitcated, but it is also more complicated (and not something we have done). In addition, the book does not
discuss these portfolio-forming rules. This doesnt mean that it isnt important in practice - to the contrary, this is probably quite practical - but most
of the intuition for how to implement these things in practice comes from
the models weve worked with (think: Treynor-Black).
Advantage: Performance Evaluation.
More than being a robust method for portfolio construction, the multifactor model has
become a standard for portfolio evaluation. Here, it is important to point out that to
use a multifactor model to evaluate portfolio performance, we do not need to assume
that the portfolio manager used the multifactor model to construct the portfolio in the
first place. There are a couple concepts to keep in mind:
The betas (called factor loadings) on the factors tell us how sensitive the portfolio return is to various factors in the factor model. If a factor loading is high
for a particular risk factor, the performance of the managers portfolio is more
sensitive to risk of that type. This is useful information to know, both for determining whether the manager has done a good job, but also in the broader scope
of things, for deciding how best to incorporate the managers portfolio into the
big picture.
Even when the manager did not use extra factors in his portfolio decision, it is
a good idea to evaluate the portfolios alpha by projecting out other relevant
risk factors (just by getting the portfolio alpha using the multifactor model). If
the manager gets apparent return, but only because hes taking a particular type
of risk, thats something the factor model can expose.
Disadvantage: Realism is Costly.
i ,RM ]
The multifactor model does not have an intuitive set of equations (think i = Cov[R
Var[RM ]
for the single-index model).
The extra factors require multiple regression, which is more difficult to implement and
to conceptualize.
As a result of the computational non-intuitiveness of multifactor models, we will tend
to stick with what is most straightforward to conceptualize.

CHAPTER 10 AND 11 NOTES - ARBITRAGE, MARKET EFFICIENCY, AND ADDITIONAL RISK FACTORS

3.3. The Fama-French Three Factor Model. By far, the most widely cited and used multifactor
model is the Fama-French Three Factor Model. Fama and French (FF) noted that two types of
stocks have consistently outperformed others over the long haul, and in many different countries
and contexts. These two types of stocks are small cap stocks and value stocks. On the basis of this
persistent outperformance, FF argued that these kinds of investments must be related to additional
risk factors in order to warrant the additional excess return.
To capture this in a factor model, they formed two factor portfolios in addition to the market
factor that we already love and know (RM ; from the single-index model) that capture the noted out
performance:
(1) Small (Market Cap)-Minus-Big (SMB) is a portfolio that holds 10 percent smallest stocks
by market capitalization while short selling the 10 percent of largest stocks by market
capitalization. The excess returns from this portfolio, RSMB , will tend to be larger when
small cap firms outperform large cap firms, which they tend to do (re: historical evidence).
(2) High (Book to Market)-Minus-Low (HML) is a portfolio that holds 30 percent of the
stocks with the highest book-to-market ratios while short selling the 30 percent of stocks
with the lowest book-to-market ratios. The excess returns from this portfolio, RHML , will
tend to be larger when small cap firms outperform large cap firms, which they tend to do
(re: historical evidence).
The resulting factor model
Ri = i + i,M RM + i,SMB RSMB + i,HML RHML + ei
has become a standard in performance evaluation for portfolio managers. Investment companies
will often include a factor for momentum, and many other proprietary factors exist. Internally at a
hedge fund or other investment management company, a great deal of effort goes into developing
the right factor model against which to judge returns.