Lecture2B APT PDF

Multi-Factor Model
Efficient Market Hypothesis
Lecture 2b: Arbitrage Pricing Theory-Beta

Pricing Model
Y. Zhang1
1 Hanqing Advanced Research Institute of Economics and Finance

Renmin University of China
Master of Finance Program
Y.Z. Introduction
Multi-Factor Model
Outline
1 Multi-Factor Model
Arbitrage Pricing Theory
Projecting SDF0 s onto the Asset Space
Multi-factor beta pricing model
2 Efficient Market Hypothesis

Market Efficiency
Y.Z. Introduction
Multi-Factor Model
Arbitrage and Law of One Price

An arbitrage opportunity arises when an investor can earn
riskless profits without making a net investment.
A trivial example of an arbitrage opportunity would arise if
shares of a stock sold for different prices on two different
exchanges.
For example, suppose IBM sold for $195 on the NYSE but
only $193 on NASDAQ. Then you could buy the shares on
NASDAQ and simultaneously sell them on the NYSE, clearing
a riskless profit of $2 per share without tying up any of your
own capital.
The Law of One Price states that if two assets are equivalent
in all economically relevant respects, then they should have
the same market price.
Law of One Price is weaker than No arbitrage. Think the A/H
premium in China mainland and hongkong exchange markets.
Y.Z. Introduction
Multi-Factor Model
Projecting SDF0 s onto the Asset Span

Assumption to guarantee the existence of SDF with finite
variance
All assets payoffs have finite variances
Law of One price holds
Recall Linear Regression:
y = Xβ + ε
X β is the
 fitted/projected
 value of y , denoted by yp
x11 x12 x13  
 x21 x22 x23  β1
Xβ =   x31 x32 x33  β2 =
 
β3
  x41 x42 x43
 
x11 x12 x13
 x21   x22   x23 
 x31  β1 +  x32  β2 +  x33  β3
     
x41 x42 x43

linear combination of columns of matrix X: ”Spanned” by
column space of X
Y.Z. Introduction
Multi-Factor Model
Linear Regression
The vector β is to minimize the sum of squared errors

RSS(β) = (y − X β)0 (y − X β)
FOC gives us: dRSS(β)
dβ = d
dβ [y 0 y − 2y 0 X β + β 0 X 0 X β] =
−2X 0 y + 2X 0 X β = 0
AssumingX 0 X is invertible, we get β = (X 0 X )−1 X 0 y
Back to: −2X 0 y + 2X 0 X β = 0 = X 0 (y − X β) = X 0 ε = 0
this means we find a β to make the error term (ε = y − X 0 β)
be orthogonal to the column space of X (or the space spanned
by the columns of X)
yp = X 0 β is the projection of y onto the space spanned by the
columns of X.
Y.Z. Introduction
Multi-Factor Model
Project SDF on the Payoffs0 Space
project m on asset payoff space(column space of X):

m = a + θ0 X + ε, where E (εX ) = 0 (orthogonal to X) and
E (ε) = 0 (orthogonal to constant)
Taking expectation: a = E [m] − θ0 E [X ]
Rewrite linear regression: m − E [m] = θ0 (X − E [X ]) + ε
set m̃ = m − E [m] and X̃ = X − E [X ], then m̃ = θ0 X̃ + ε
h i h i
by orthogonality: E X̃ ε = E X̃ m̃ − X̃ 0 θ = 0
h i h i h i−1 h i
E X̃ m̃ = E X̃ X̃ 0 θ ⇒ θ = E X̃ X̃ 0 E X̃ m̃
θ= −1
E (X − E [X ]) (X − E [X ])0

E [(X − E [X ]) (m − E [m])]
θ = Σ−1
X Cov (X , m)
Y.Z. Introduction
Multi-Factor Model
Project SDF on the Payoffs0 Space
Projection of m is: a + θ0 X = E [m] − θ0 E (X ) + θ0 X =

| {z }
a
E (m) + θ0 (X − E [X ]) = E [m] + Cov (X , m)0 Σ−1
X (X − E [X ])
Y.Z. Introduction
Multi-Factor Model
APT-1
Let F = (f1 , f2 , · · · , fk ) be the factor and have nonsingular

covariance matrix, ΣF .
Let project R on space of factors:
Ri = E [Ri ] + Cov (F , Ri )0 Σ−1
F (F − E [F ]) + ε
Cov (F , Ri )0 Σ−1
F (F − E [F ]) is systematic risk
ε is called idiosyncratic risk
The APT asserts that when returns have a factor structure,
there is beta pricing model with f1 , f2 , · · · , fk as the factors.
Thus, ”systematic risk factors” are ”beta-pricing factors”.
CAPM is derived from equilibrium
APT is derived from the factor structure and the existence of
SDF.
Y.Z. Introduction
Multi-Factor Model
APT-2
For Any SDF, m: 1 = E [mRi ]
E [mR
i] =
E m × E [Ri ] + Cov (F , Ri )0 Σ−1

F (F − E [F ]) + ε =
E [m]E [Ri ] + Cov (F , Ri )0 Σ−1
F (E [mF ] − E [m]E [F ]) + E [mε]
0 −1
1 = E [m]E [Ri ] + Cov (F , m) ΣF Cov (F , Ri ) + E [mε]
Assuming E (m) 6= 0,
1
E [Ri ] = E [m] 1
− E [m] Cov (F , m)0 Σ−1 E [mε]
F Cov (F , Ri ) + E [m]
What is about E [mε]? It is the price of idiosyncratic risk.
In a large portfolio, it can be diversified.
APT is approximately TRUE for most assets:
with only finitely many assets, the idiosyncratic risk of a
diversified portfolio may be small, but it is not zero.
Even with infinitely many assets, it is may not be possible for
all investors to hold well-diversified portfolio.
Y.Z. Introduction
Multi-Factor Model
Well-Diversified Portfolios
Rp = E (Rp ) + βp F + εp
βp = Σwi βi ,εp = Σwi εi and E (Rp ) = Σwi E (Ri )
σp2 = βp2 σF2 + σ 2 (εp )
σ 2 (εp ) = Var (Σwi εi ) = Σwi2 σ 2 (εi )
If the portfolio were equally weighted, wi = 1/n, then
2 2
Σwi2 σ 2 (εi ) = Σ n1 σ 2 (εi ) = n1 Σ σ n(εi ) = n1 σ̄ 2 (εi )
when n is large, nonsystematic variance approaches zero.
Y.Z. Introduction
Multi-Factor Model
Example: Multi-factor model
In efficient markets, profitable arbitrage opportunities will

quickly disappear.
Ri = E (Ri ) + βi,1 UGDP + βi,2 IR + ei .
UGDP is unanticipated growth in GDP.
IR is unexpected change in interest rates.
E (RChinaAir ) = E (RChinaAir ) + β1,GDP RPGDP + β2,IR RPIR
E (RChinaAir ) = 4% + 1.2 × 6% + −0.3 × −7% = 13.3%
Y.Z. Introduction
Multi-Factor Model
Example: single-factor model
Ri = E (Ri ) + βi F + ei .
F is the unexpected change of factor.
If factor is RM , then F is RM − E (RM )
Ri = E (Ri ) + βi [RM − E (RM )] + ei
The expected return of individual stock is:
E (Ri ) = αi + βi E (RM ).
Ri = αi + βi RM + ei
Y.Z. Introduction
Multi-Factor Model
Y.Z. Introduction
Multi-Factor Model
Executing Arbitrage
a well-diversified (therefore zero residual) portfolio, P:

E (Rp ) = αp + βp E (RM )
Since neither M nor portfolio P have residual risk, the only
risk to the returns of the two portfolios is systematic, derived
from their betas on the common factor.
Construct a zero-beta portfolio, called Z, from P and M by
appropriately selecting weights:
wM = 1 − wp
βZ = wp βp + (1 − wp ) βM = 0, where βM = 1
1 β
wp = 1−β p
, wM = 1 − wp = − 1−βp p
αZ = wp αp + (1 − wp ) αM = wp αp
the beta of Z is zero
1
E (RZ ) = wp αp = 1−β p
αp
Y.Z. Introduction
Multi-Factor Model
Arbitrage Strategy
If βp < 1, and the risk premium of Z is positive (implying that

Z returns more than the risk-free rate), borrow and invest the
proceeds in Z.
For every borrowed dollar invested in Z, you get a net return,
1
1−βp αp
ifβp > 1, the risk premium is negative; therefore, sell Z short
and invest the proceeds at the risk-free rate.
Hence, No Arbitrage means E (Rp ) = βp E (RM )
this is the SML derived from APT.
Y.Z. Introduction
Multi-Factor Model
APT:
Based on the law of one price and no arbitrage.
Multi-factor (characteristic) model of asset pricing
In basic form, not equilibrium asset pricing model, unlike
CAPM. CAPM model is based on the equilibrium model.
The equilibrium model which makes hypotheses about
agents−consumers, producers, investors and some form of
rationality hypothesis leading to the specification of
maximization problems under constraints.
To get the APT, we don0 t have to assume that everyone is
optimizing
Recall that we did need this assumption to get the CAPM.
Y.Z. Introduction
Multi-Factor Model
APT Assumptions:
APT requires fewer assumptions than CAPM, namely:
All securities have finite expected values and variances
Some agents can form well diversified portfolios
There are no taxes
There are no transaction costs
There exists a (stable) set of factors (random quantities) that
are essential and exhaustive determinants of all asset returns.
Factors may be macroeconomic in nature (e.g., the random
growth rate of gross domestic product, GDP), or behavioral
(e.g., the momentum factor to be considered shortly)
Y.Z. Introduction
Multi-Factor Model
APT Theory:
) + β 0 F + εi
Ri = E (Ri 
f1
 f2 
F = . 
 
.
 . 
fk
E (F ) = 0k , Cov (fi , fj ) = 0 ∀i 6= j
Cov (εi , fj ) = 0 ∀i, j E (εi ) = 0
Given the above structure, Ross (1976) demonstrates that if
there are no-arbitrage opportunities, then there exists a k × 1
vector of factor risk premia λ such that for any asset i,
E (Ri ) ≈ β 0 λ
The conclusion of the APT is an approximation
No directly provide testable implications for asset returns
When market is Complete, there exists a unique SDF. APT
degenerates to beta-pricing model.
Y.Z. Introduction
Multi-Factor Model
Beta Pricing Model

E (R) = Rz + λ cov (f ,R) cov (f ,R)
Var (f ) , where Var (f ) is called beta
Rz is the expected value of an asset return satisfying
cov (f , Rz ) = 0  
f1
 f2 
A multifactor beta pricing model with factors F= .
 
 ..


fk
E (R) = Rz + λ0 Σ−1
F Cov (F , R), where λ is the factor risk
premium.
ΣF is the covariancew matrix of the vector
 F 
cov (f1 , R)
 cov (f2 , R) 
Cov (F , R) denotes the column vector, 
 
.. 
 . 
cov (fk , R)
Y.Z. Introduction
Multi-Factor Model
The number of factor in a beta pricing model is not uniquely

determined.
Given a k factor model, we can always use λ0 Σ−1
F F as a single
factor.
If a factor is a return, then its factor risk premium is its
ordinary risk premium,m treating Rz as a proxy of risk-free
return.
If a factor is an excess return, then the factor risk premium is
simply the expected value of the factor.
All factors can be replaced by returns or excess returns. These
returns should be the ones which have the maximum
correlations with factors.
These returns can be obtained by orthogonal projection of the
factor on the space of returns and a constant. These are
called factor-mimicking return.
Y.Z. Introduction
Multi-Factor Model
Returns as Factors
Consider a k-factor model and factor is return.

E (fi ) = Rz + λ0 Σ−1
F Cov (F , fi )
The vector Cov (F, fi ) is the ith column of matrix ΣF .
0
 .. 
 . 
 
 0 
−1
 
 1 , where the ith element is 1 and 0
ΣF Cov (F , fi ) is  
 0 
 
 .. 
 . 
0
elesewhere.
λ0 Σ−1
F Cov (F , fi ) = λi = E (fi ) − Rz
Y.Z. Introduction
Multi-Factor Model
Excess Returns as Factors
If factor is excess return. Any R and R + fi is also a return.

E (R) = Rz + λ0 Σ−1
F Cov (F , R)
E (R + fi ) = Rz + λ0 Σ−1 0 −1
F Cov (F , R) + λ ΣF Cov (F , fi )
Subtracting the 1st from 2nd equation, we have
E (fi ) = λ0 Σ−1
F Cov (F , fi ) = λi
Y.Z. Introduction
Multi-Factor Model
Discount Factor and Beta-pricing Model
Beta pricing models are equivalent to linear models for the

discount factor m,
E (Ri ) = γ + βi0 λ ⇐⇒ m = a + b 0 f
Proof:
Folding the mean into a so E (f ) = 0
” =⇒ ”
Suppose m = a + b 0 f and E (mRi ) = 1
E (Rf 0 )
E (Ri ) = E (m)1
− covE(m,R
(m)
i)
= 1a − Var (f ) Vara(f ) b =
0
1 0 0 −1 E (ff )
a − E (Rf ) E (ff ) a b
Remember the simple linear regression: Ri = β0 + β1 fi + εi
Σn (fi −f¯)(Ri −R̄ ) 1 n ¯
n Σi=1 (fi −f )(Ri −R̄ ) E (Rf 0 )
β̂1 = i=1 n 2 = 2 = Var (f ) =
Σi=1 (fi −f¯) ¯
n Σi=1 (fi −f )
1 n
−1
E (Rf 0 ) E (ff 0 ) because we fold mean of factor into a
E (ff 0 )
γ = 1a and λ = − a b
Y.Z. Introduction
Multi-Factor Model
Proof
Proof:
” ⇐= ” 0
λ = − E (ffa ) b = − Vara(f ) b = −γcov (f , f 0 ) b = −γE (mf )
E (Ri ) = γ + λ0 βi = 1a − 1a βi0 cov (f , f 0 ) b → aE (R) =
1 − E (Rf 0 ) E (ff 0 )−1 cov (f , f 0 ) b
Because E (f ) = 0, cov (f , f 0 ) = E (ff 0 ).
aE (R) = 1 − E (Rf 0 ) b −→ E (R [a + b 0 f ]) = 1
So, m = a + b 0 f
Y.Z. Introduction
Multi-Factor Model
Which factors to select?
Y.Z. Introduction
Multi-Factor Model
Macroeconomic Factor Models
CRR 1986 Paper: Economic forces and the stock market

The first widely studied macro factor model.
Examine 5 macro variables that are related either to changes
in expected cash flows or discount rates in a stock valuation
model
IP = monthly growth rate in industrial production
EI = change in expected inflation
UI = unanticipated inflation
CG = unanticipated change in the risk premium (Baa and
under return - Aaa bond return)
GB = unanticipated change in the term structure (long term
government bond return - Treasury Bill rate)
Y.Z. Introduction
Multi-Factor Model
Factor Mimicking Portfolio
The ”factors”
Need not be returns (though they may be);
Need not be orthogonal,
Need not be serially uncorrelated
Need not be conditionally or unconditionally mean-zero.
When the factors are not already returns or excess returns, it
is convenient to express a beta pricing model in terms of its
factor-mimicking portfolios rather than the factors themselves.
Compared to macroeconomic factors, their mimicking
portfolios contain more relevant information and less noise for
asset pricing.
For portfolio management factors need to be translated to
trading strategies.
Y.Z. Introduction
Multi-Factor Model
Fama-French 3 Factors Model
The Cross-Section of Expected Stock Returns. JoF 1992

Common risk factors in the returns on stocks and bonds. JFE
1993
See Blackboard
Y.Z. Introduction
Multi-Factor Model
Momentum Trading Strategy
Returns to Buying Winners and Selling Losers: Implications for

Stock Market Efficiency, JoF 1993
Select stocks on the basis of returns over the past J months
and holds them for K months
At the beginning of each month t the securities are ranked in
ascending order on the basis of their returns in the past J
months.
Based on these rankings, ten decile portfolios are formed that
equally weight the stocks contained in the top decile, the
second decile, and so on.
In each month t, the strategy buys the winner portfolio and
sells the loser portfolio, holding this position for K months.
See Table I in paper
Y.Z. Introduction
Multi-Factor Model
Pairs Trading Strategy

Pairs Trading: Performance of a Relative-Value Arbitrage Rule,
RFS 2006
Form pairs over a 12-month period (formation period) and
trade them in the next 6-month period (trading period).
Screen out all stocks from the CRSP daily files that have one
or more days with no trade.
Construct a cumulative total returns index for each stock over
the formation period.
Choose a matching partner for each stock by finding the
security that minimizes the sum of squared deviations between
the two normalized price series. Pairs are thus formed by
exhaustive matching in normalized daily price space, where
price includes reinvested dividends.
We study the top 5 and 20 pairs with the smallest historical
distance measure.
Y.Z. Introduction
Multi-Factor Model
Fama-French-Carhart 4-factor model
The Cross-Section of Expected Stock Returns. JoF 1992

Common risk factors in the returns on stocks and bonds. JFE
1993
See Blackboard
Y.Z. Introduction
Multi-Factor Model
Market Efficiency
Market Efficiency
Maurice Kendall (1953) found no predictable pattern in stock

price changes
Stock price changes follow a random walk, an unit root
process
If prices are determined rationally, then only new information
will cause them to change.
A random walk would be the natural result of prices that
always reflect all current knowledge.
Stocks already reflect all available information is referred to as
the efficient market hypothesis (EMH).
Y.Z. Introduction

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Multi-Factor Model

Efficient Market Hypothesis

Lecture 2b: Arbitrage Pricing Theory-Beta

1 Hanqing Advanced Research Institute of Economics and Finance

Master of Finance Program

2 Efficient Market Hypothesis

Arbitrage and Law of One Price

Projecting SDF0 s onto the Asset Span

x41 x42 x43

The vector β is to minimize the sum of squared errors

Project SDF on the Payoffs0 Space

project m on asset payoff space(column space of X):

Project SDF on the Payoffs0 Space

Projection of m is: a + θ0 X = E [m] − θ0 E (X ) + θ0 X =

Let F = (f1 , f2 , · · · , fk ) be the factor and have nonsingular

Example: Multi-factor model

In efficient markets, profitable arbitrage opportunities will

Example: single-factor model

a well-diversified (therefore zero residual) portfolio, P:

If βp < 1, and the risk premium of Z is positive (implying that

Beta Pricing Model

The number of factor in a beta pricing model is not uniquely

Consider a k-factor model and factor is return.

Excess Returns as Factors

If factor is excess return. Any R and R + fi is also a return.

Discount Factor and Beta-pricing Model

Beta pricing models are equivalent to linear models for the

Which factors to select?

Macroeconomic Factor Models

CRR 1986 Paper: Economic forces and the stock market

Factor Mimicking Portfolio

Fama-French 3 Factors Model

The Cross-Section of Expected Stock Returns. JoF 1992

Momentum Trading Strategy

Returns to Buying Winners and Selling Losers: Implications for

Pairs Trading Strategy

Fama-French-Carhart 4-factor model

The Cross-Section of Expected Stock Returns. JoF 1992

Maurice Kendall (1953) found no predictable pattern in stock

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