Академический Документы
Профессиональный Документы
Культура Документы
Page 1 of 49
Chapter 8: Securities and portfolios - risk and return - Learning outcomes
Learning outcomes
By the end of this chapter, and having completed the essential readings and activities, you
should be able to:
explain how risk affects the return of a risky asset, and hence how risk affects the value of
the asset in equilibrium
calculate risk and return for individual securities and portfolios, and understand the basic
statistical tools of expected returns, standard deviations and covariances
explain the mean-standard deviation portfolio theory, and the meaning of its key concepts
(efficient frontier, feasible region, capital market line, and optimal portfolio)
illustrate the effects of diversification
explain the main assumptions and results of the CAPM
illustrate the key concepts of the CAPM (beta and security market line)
explain the main assumptions and results of the APT
compare the theoretical and empirical validation of the CAPM and APT.
Essential reading
Brealey, Myers and Allen 2010. Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate
Finance. (Boston, London: McGraw-Hill/Irwin, 2010) tenth edition Chapters 7 and 8.
Mishkin and Eakins 2009. Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston,
London: Addison Wesley, 2009) Chapter 4.
Page 2 of 49
Chapter 8: Securities and portfolios - risk and return - 1. Introduction
1. Introduction
Study Guide, pp. 160
Page 3 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
Risk and return are the two main attributes of a financial security.
Uncertain return
However, when securities are originally acquired, their returns are usually uncertain because
their prices are subject to changes.
E ( R) p1 R1 p2 R2 ... pn Rn (8.1)
where:
E(R) = expected return
Ri = return of the state of nature i
n = number of possible states of nature (outcomes)
pi = probability of occurrence of the return Ri.
Page 4 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
Deviation = Ri - E(R)
More formally, to calculate the standard deviation of returns we need to calculate the expected return
E(R), then to subtract the expected return from each return to get a deviation.
Then we square each deviation and multiply it by the probability of occurrence of that outcome.
Finally we add up all these weighted squared deviations and take the square root, that is:
p1 ( R1 E ( R)) 2 p2 ( R2 E ( R)) 2 ... pn ( Rn E ( R)) 2 (8.2)
Page 5 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
Activity 8.1
Consider Second Class, a stock with a return of 16 per cent two-thirds of the time and 9 per cent one-
third of the time. Then answer the following questions:
Is the Second Class stock more or less risky than the First Class stock?
Page 6 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
What are the levels of risk and return of financial securities around the world? The next activity enables
you to find out some empirical evidence on risk and average returns associated with different classes of
securities (stocks and bonds) for different countries.
Activity 8.2
Download the Credit Suisse Global Investment Returns Yearbook 2010, available at:
http://tinyurl.com/DMS2010
Carefully read the country profiles for the 19 countries focusing on figure 3 in each profile which shows
the returns and risks of major asset classes from 1900 to 2009.
Let us now focus on the USA. To find out the risk and average returns associated with different classes
of securities in the US market, move to the next activity.
Page 7 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
Activity 8.3
Visit the Morningstar website at
http://corporate.morningstar.com/ib/documents/SampleContent/MktChartsImages.pdf and analyse the
figure ‘Stock, Bonds, Bills and Inflation’.
The performance of each security class coincides with the intuitive risk ranking.
risk is measured as risk premium, i.e. the extra return versus Treasury bills
return is measured by the average nominal and real annual rate of return
Treasury bills were the least profitable (3.9 per cent nominal annual rate of return), but
were also virtually risk-free (0 per cent risk premium).
Common stocks obtained the highest average return (13 per cent nominal annual return),
but also experienced the highest risk (9.1 per cent risk premium).
Page 8 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
Page 9 of 49
Chapter 8: Securities and portfolios - risk and return - 2. Risk and return of a single financial
security
Activity 8.4
Visit the Morningstar website at
http://corporate.morningstar.com/ib/documents/SampleContent/MktChartsImages.pdf and analyse the
figure on ‘Reduction of risk over time’.
between –50 per cent and +135 per cent for small company stocks, and
between 0 per cent and +20 per cent for Treasury bills.
between +5 per cent and +20 per cent for small company stocks, and
between 0 per cent and +7 per cent for Treasury bills.
Note that when the holding period is up to 20 years, the average returns of different security class
converge towards the average nominal values analysed above. Specifically, they are:
12.6 per cent for small company stocks,
10.4 per cent for large company stocks,
5.5 per cent for government bonds and
3.7 per cent for Treasury bills.
Page 10 of 49
Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:
portfolio analysis
Portfolio
A portfolio is a combination of different assets held by an investor.
Portfolio weight
The share of the value of each individual asset over the total value of the portfolio is referred to as the
weight of the asset in the portfolio.
Obviously the sum of the weights of all the assets of the portfolio must be one (unity).
Activity 8.5*
Calculate the portfolio weight for Microsoft.
The solution to this activity can be found at the end of the subject guide in Appendix 1.
E ( R p ) w1 E ( R1 ) w2 E ( R2 ) ... wn E ( Rn ) (8.3)
where: wi = portfolio weight for stock i.
Example of E(Rp)
Going back to our example, assume that the expected return over the coming year will be 10 per cent
for The Coca Cola Company and 15 per cent for Microsoft.
The expected return of the portfolio of the investor is 11.5 per cent = (0.698 × 0.10 + 0.301 × 0.15).
Page 11 of 49
Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:
portfolio analysis
A positive correlation means that the two returns tend to move together;
a negative correlation implies that the two returns tend to move in opposite directions;
a zero correlation indicates that the returns of the stocks are wholly unrelated.
Correlation coefficient
A statistical measure of correlation is known as the correlation coefficient.
It is simply the covariance divided by the product of the respective standard deviations.
Formally the correlation coefficient is defined as follows:
1, 2
1, 2 (8.4)
1 2
where: σ1,2 = covariance between stocks 1 and 2, which is a measure of the degree to which
the two stocks move together over time (covary).
Portfolio variance
The portfolio variance is the weighted average of several components:
a) the variance of the returns on each stock (σi2 with i = 1,2) multiplied by the square of its portfolio
weight (wi2);
b) the covariance between stocks 1 and 2. Formally, this is:
Portfolio SD
The portfolio standard deviation is of course the square root of the variance.
Note that the standard deviation of a portfolio is simply the weighted average of uncorrelated
(i.e. ρ1,2= 0).
Page 12 of 49
Chapter 8: Securities and portfolios - risk and return - 3. Risk and return of a portfolio:
portfolio analysis
Activity 8.6
Using the same weights and standard deviations given above, calculate the portfolio return variance in
these three cases:
1. Negative correlation between returns, ρ1,2 = – 0.3.
The solution to this activity can be found at the end of the subject guide in Appendix 1
Page 13 of 49
Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification
4. Benefits of diversification
Study Guide, pp. 165 – 166
Brealey, Myers and Allen 2010, pp. 196 - 198
Note that diversification does not work in the extremely rare cases where returns move
perfectly together.
Conversely, if returns are uncorrelated, it is possible through diversification to reduce risk to zero.
Page 14 of 49
Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification
Activity 8.7
Read Mishkin and Eakins (2009), p.75 (footnote 2) and summarise their example of how diversification
works.
Page 15 of 49
Chapter 8: Securities and portfolios - risk and return - 4. Benefits of diversification
Activity 8.8
Now think about what an investor in say, Germany, can do to achive greater risk reduction.
Page 16 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
The aim of this section is to identify the optimal holding of risky assets for a risk-averse agent, since
the investor seeks to minimise risk.
This is known as the mean-standard deviation portfolio theory, and was developed by Markowitz (1952).
Utility function
The utility function is increasing in expected portfolio returns, and decreasing in return standard
deviation.
Page 17 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
The diagram shown in Figure 8.5 describes the mean (Y-axis) and the standard deviation (X-axis) of
any risky asset, and each point in this diagram represents an asset.
As the portfolio weights for the two assets vary from 0 to 1,
As the portfolio weights vary, the new portfolios trace out a curve that includes assets X and Y.
Page 18 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Set d/dw1(σp) = 0,
w1 = (σ22 - σ1σ2 ρ1,2) / (σ12 + σ22 - 2 σ1σ2ρ1,2)
The weight of the other asset (w2) in the minimum variance portfolio is found from: w2 = 1 – w1
Using the two calculated weights in equations 8.3 and 8.5 will give us the expected return and standard
deviation of the minimum variance portfolio.
Page 19 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Efficient frontier
In the absence of a risk-free asset, this set of portfolios (on the frontier and to the right of V) is termed
the efficient frontier (as shown in Figure 8.6).
Page 20 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Activity 8.9*
Risky asset A has an expected return of 15% and a standard deviation of 25%
Risky asset B has an expected return of 35% and a standard deviation of 40%. If the
correlation between the returns on assets A and B is 0.25 and the assets are combined in
the following proportions:
A B
1 1 0
2 .75 .25
3 .5 .5
4 .25 .75
5 0 1
Calculate
i. the expected return and standard deviation for the 5 portfolios
ii. the expected return and standard deviation for the minimum risk portfolio
iii. plot all the portfolios calculated in (i) and (ii) on a graph and identify the efficient frontier.
The solution to this activity can be found at the end of the subject guide in Appendix 1.
Page 21 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Preference of investor
In order to identify the optimal portfolio (of two risky assets) for a given investor, we need to identify a
set of preferences for this investor.
Indifference curve
This set of preferences towards risk and return can be represented by an indifference curve. Figure
8.6 shows two indifference curves for investors A and B respectively.
Page 22 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Feasible region
The set of all points representing portfolios made from N assets is called the feasible set or feasible
region.
Same shape
The shape of the frontier is the same as in the case of two risky assets (as drawn in Figure 8.5).
Page 23 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Activity 8.10*
Consider a rational investor who has to choose one portfolio. Which portfolio would always be preferred
for each of the following pairs of portfolios?
1. Portfolio A E(R) = 17% σ = 16%
Portfolio B E(R) = 17% σ = 6%
2. Portfolio C E(R) = 15% σ = 16%
Portfolio D E(R) = 12% σ = 16%
The solution to this activity can be found at the end of the subject guide in Appendix 1.
Page 24 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
In the last section, the mean-standard deviation frontier has been identified by assuming that the return
correlation coefficient was between plus and minus one.
Figure 8.8 shows the locus of the return-standard deviation frontier assuming different correlation
coefficients.
Page 25 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Fig 8.9 Mean-SD frontier with risk-free asset and N risky assets
In Figure 8.9 we have plotted the expected return and risk of a portfolio composed by the risk-free asset
and a combination of risky assets.
We now need to identify the optimal portfolio for an investor who wants to hold a risk-free asset in
addition to N risky assets.
Page 26 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
As all points along CML1 are superior (in terms of return for a given risk) to points on
say, CML2.
Two-fund separation
We have achieved a very important result known as two-fund separation. Any risk-averse investor
can form the optimal portfolio by combining two funds.
Degree of risk-aversion
The degree of risk-aversion determines the portfolio weights placed on the two funds.
points to the left of K represent lending portfolios where the investor invests positive amounts in
the risk-free asset.
Points to the right of K represent borrowing portfolios where the investor borrows at the risk-free
rate to increase the amount of funds they can invest in the optimal risk assets portfolio K.
Page 27 of 49
Chapter 8: Securities and portfolios - risk and return - 5. Mean-standard deviation portfolio
theory
Example of lending
An example will help to illustrate this. Suppose an investor has $10,000 to invest. The expected return
on portfolio K is 15 per cent and the standard deviation of returns is 20 per cent. The risk-free rate of
interest is 5 per cent.
A risk-averse investor may wish to invest half of his/her wealth ($5,000) in the risk-free asset and half
($5,000) in portfolio K.
What is the expected return and risk for this efficient portfolio, say, A?
Answer:
E(RA) = 0.5 × 5% + 0.5 × 15% = 10%; σA = 0.5 × 0 + 0.5 × 20% = 10%
Example of borrowing
A more risk-seeking investor may choose to borrow, at the risk-free rate, an amount of $5,000 giving
him/her a total of $15,000 to invest in portfolio K.
The expected return and risk of this borrowing portfolio, say B, is given by:
Answer:
E(RB) = −0.5 × 5% + 1.5 × 15% = 20%; σB = −0.5 × 0 + 1.5 × 20% = 30%
Activity 8.11
How can investors identify the best set of efficient portfolios of common stocks?
What does ‘best’ mean?
Page 28 of 49
Chapter 8: Securities and portfolios - risk and return - 6. Asset pricing models
which does not require the assumption that investors choose their portfolios on the basis of
means and standard deviations,
but rather on the basis that two assets that are the same cannot sell at different prices.
Page 29 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Assumptions of CAPM
To begin our discussion of the CAPM, let us first present the assumptions that underlie the theory:
1. Investors maximise their utility only on the basis of expected portfolio returns and return
standard deviations.
3. Markets are perfect and frictionless. (i.e. no taxes on sales or purchases, no transaction costs
and no short sales restrictions).
4. Investors have homogeneous beliefs regarding future returns, which means that all investors
have the same information and assessment about expected returns, standard deviations and
correlations of all feasible portfolios.
Page 30 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
such as the S&P500 (500 typically larger market capitalisation stocks traded on the NYSE and
Nasdaq).
The demand for risky assets is represented by the optimal portfolio chosen by investors, whereas
Page 31 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
E ( Ri* ) R f i [ E ( RM ) R f (8.6)
where:
βi = the covariance of the returns on asset i with the return on a market portfolio, divided by the
variance of the market return. Formally, this is: βi = σiM / σ2M
[E(RM) – Rf] = market risk premium, which is the amount by which the return of the market
portfolio is expected to exceed the risk-free rate.
Usage of Eqn 8.6: finding expected return = risk-free rate + market risk premium *
beta
The CAPM enables us to figure out what returns investors are looking for from particular security.
Specifically, under the CAPM framework, the expected return of a given risky asset (or portfolio of
assets) is equal to the risk-free rate plus a market risk premium multiplied by the asset or portfolio
beta.
We showed estimates of the risk-free rate in the paragraph on ‘Empirical evidence on risk, return and
their relationship’; and we will do the same for beta and market risk premium in the next paragraphs.
Beta
βi = the covariance of the returns on asset i with the return on a market portfolio, divided
by the variance of the market return. Formally, this is: βi = σiM / σ2M
From SD to Beta
Under the CAPM framework, the standard deviation of an asset by itself is no longer an important
determinant of the expected return of that asset.
Page 32 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Example of Beta
Example: Consider the beta of Microsoft stock, which is equal to 1.527 (this estimate is provided by
various data service organisations such as Bloomberg, and it is calculated by using a record of past
stock values).
This β value means that on average, when the market return increases by an extra 1 per cent,
Microsoft’s return will rise by an extra 1.527 per cent.
When the market decreases by an extra 2 per cent, Microsoft stock return will fall an extra 2
×1.572 = 3.144 per cent.
Activity 8.13
Decide whether each of the following statements is true or false.
The expected return of an asset with a beta of 0.5 is half the expected return of the market.
(True / False)
If the beta of an asset is lower than 0, the CAPM implies that its expected return will be lower
than the interest rate. (True / False)
Beta of a portfolio
The beta of a portfolio (βp) is simply the weighted average of the betas of the individual assets in the
portfolio (βi), where the weights are the portfolio weights (wi). Formally this is:
p wi i (8.7)
Page 33 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
These values are somewhat lower than the historical average risk premium over the longer period
1926–2000: for example, for the USA the risk premium over 1926–2000 was equal to 9.1 per cent (=
0.13 – 0.039; see Figure 8.2).
Some of these variations may reflect differences in risk (i.e. Italian stocks may have been particularly
variable and investors may have required a higher return to compensate).
Page 34 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Page 35 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
SML
Therefore the security market line is a straight line emanating from the risk-free point and passing
through the market portfolio.
Equilibrium on SML
In equilibrium every stock must lie on the security market line: no stock can lie below or above the
security market line.
This happens because any investor can always obtain a market risk premium of βi[E(RM) – Rf]
by holding a combination of the market portfolio and the risk-free asset.
Page 36 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Activity 8.14*
Assume that the return on US Treasury bills is 3 per cent, the expected return on the market portfolio is
12 per cent. On the basis of the CAPM:
1. Draw a graph showing the relationship between the expected return and beta.
4. What is the beta of a stock if the market return is expected to be 12.5 per cent?
The solution to part of this activity can be found at the end of the subject guide in Appendix 1.
Page 37 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Diversifiable risk
The risk that can be eliminated by diversification is known as diversifiable risk (or unique, specific,
non-systematic risk), which is the risk peculiar to a company or its immediate competitors.
Market risk
However, there is some risk that cannot be avoided, regardless of how much investors diversify. This
risk is known as market risk (or systematic, undiversifiable risk), which can be thought of as the risk
of the market as a whole.
Page 38 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
If you have only one stock, diversifiable risk is very important; however,
The magnitude of market risk depends on the average betas of the securities included in the portfolio.
Page 39 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Standard CAPM
The CAPM developed in the previous section is termed the standard CAPM because it provides a
complete description of the behaviour of capital markets if each of the underlying assumptions are held.
The removal of these assumptions leads to the development of the non-standard forms of the CAPM.
(Note that in practice none of these modified versions is as widely used as the standard CAPM.)
Page 40 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Tests support for the CAPM, but less rapidly than predicted
Overall, these tests provide broad support for the CAPM by showing that the expected return
increased with beta over the period 1931–91, even if less rapidly than the CAPM has
predicted.
This means that high-beta stocks performed better than low-beta stocks,
but the difference in their actual returns was not as great as the CAPM would predict.
Counter argument: test only use actual return, but not E(R)
However, the supporters of the CAPM argue that the evidence could be due to the fact that the CAPM
itself is concerned with expected returns, whereas the tests only use actual returns.
Actual returns do reflect expectations, but they are also largely affected by noise.
Factors such as firm size, book-to-market ratio, price-to-earnings ratio and dividend yield
This contrasts with the CAPM, which predicts that beta is the only factor that explains expected
returns.
Page 41 of 49
Chapter 8: Securities and portfolios - risk and return - 7. Capital Asset Pricing Model (CAPM)
Page 42 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
The alternative asset pricing paradigm, known as Arbitrage Pricing Theory (APT) is, in some ways, less
complicated than the CAPM.
The basic idea of factor models is that all common variations in stock returns are generated by
movements in one factor (or a set of factors).
One-factor model
The simplest factor model is a one-factor model, which assumes that there is only one factor.
Formally, it can be written as (8.8):
Ri a i bi1 F1 i , E ( i ) 0 (8.8)
where:
ai = E(R) when Fi = 0
ai = expected level of return for stock i if all factors have a value of zero.
F1 = Value of Factor 1
F1 = value of the factor 1 that affects the returns on stock i. The factor is posited to affect all stock
returns, although different stocks can have different sensitivities.
The factor can be represented by macroeconomic conditions, financial conditions or political events.
Examples are:
Page 43 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
Examples of the idiosyncratic return can be a legal action against the company of stock i,
or the unexpected departure of a company’s CEO.
Multi-factor model
A generalisation of equation (8.8) represents a multi-factor model, where a set of j factors affects the
returns on stock i (8.9):
Page 44 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
RP = 0.045 + 0.85F1 + εP
Activity 8.15*
Assume that the portfolio weights of the above stocks (X and Y) are 0.25 and 0.75. Using the data of the
previous example, compute the portfolio return representation.
The solution to this activity can be found at the end of the subject guide in Appendix 1.
Page 45 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
1. No arbitrage opportunities
1. There are no arbitrage opportunities. Arbitrage opportunities represent the possibility of earning
riskless profits by taking advantage of differential pricing for the same asset.
There are two possible ways to define arbitrage strategies.
1. First, to invest in a set of assets that yield positive immediate cash inflow (obtained by the sale
of assets at a
relatively high price and the simultaneous purchase of the same assets at a relatively low price),
with no loss in the future.
2. Second, to invest today in costless investment strategy, and to obtain positive future cash
inflows (as described above). In both cases, when returns are certain, any investor who prefers
greater returns to lesser returns would invest as much as possible. Under the APT, these
investment strategies should not be permitted in properly functioning financial markets.
Under the APT, the absence of arbitrage opportunities places restrictions on the relationship between
the expected returns on individual assets (and hence on a well-diversified portfolio) given the factor
structure underlying returns.
Page 46 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
Key of APT
The key to the APT is that a factor model with no arbitrage opportunities implies that assets with the
same factor sensitivities must offer the same expected returns in financial market equilibrium.
Expected risk premium {E(Rx)* - Rf} depends on sum of expected risk premiums
of each factor (λj) * factor sensitivity (bj)
Therefore the expected risk premium on an individual asset (equal to the expected return on
an individual asset minus the risk-free rate) depends on the sum of the expected risk
premiums associated with each factor multiplied by the asset sensitivity to each of these
factors.
Thus the expected return on an individual asset can be written as:
where:
λj = (RFj– Rf), which is the risk premium over the risk-free rate associated with factor j.
Page 47 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
Activity 8.16*
Consider a two-factor APT model. The factors and associated risk premiums are:
Change in GNP 6%
Assuming a risk-free rate equal to 6 per cent, calculate the expected rates of return on the following
stocks:
a. A stock whose return is uncorrelated with all the two factors.
The solution to this activity can be found at the end of the subject guide in Appendix 1.
Page 48 of 49
Chapter 8: Securities and portfolios - risk and return - 8. Arbitrage Pricing Theory (APT)
The APT provides an interesting alternative perspective to that of the CAPM on the nature of equilibrium.
From a theoretical point of view, however, the theory is far from easy to implement.
(solving most of the problems presented in the previous subsection on the theoretical limitations
of the CAPM).
(unlike the CAPM, which collapses all the macroeconomic factors into the market portfolio).
Page 49 of 49