Chapter 16: The Arbitrage Pricing Model APT A New Approach to Explaining Asset Prices

APTWhat Is It? Estimating and Testing APT APT and CAPM Conclusion

APT What Is It?

CAPM is criticized because of 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 applies to well diversified portfolios and not necessarily to individual stocks. With APT. it is possible for some individual stocks to be mispriced - not lie on the SML. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. APT can be extended to multifactor models.

APT What Is It?

APT What Is It? Its based on the law of one price: two items that are the same cant sell at different prices. CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark APT is an alternative pricing theory to the CAPM with fewer assumptions: Assumptions of Arbitrage Pricing Theory (APT) 1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty 3. The stochastic process generating asset returns can be presented as K factor model (to be described) Assumptions of CAPM that Were Not Required by APT APT does not assume A market portfolio that contains all risky assets, and is mean-variance efficient Normally distributed security returns Quadratic utility function

A PT Model

The APT assumes that the stochastic process generating asset returns can be represented as a K factor model of the form: 1. Returns (rate or total) on individual assets follow a multi-index model: N

Ri = ai bik I K ei
K 1

where ai, bi1, . . . , biK are (asset-specific) constants. I1, I2, . . . , IK are random variables which represent factors or indices which affect asset returns. ei is a noise term with mean zero Impose usual model assumptions for multi-index model: cov(Ii, Ik) = 0 , i K cov(IK, ei) = 0 cov(ei, eK) = 0 , I K

Additional Assumptions for APT

There are sufficiently large number of well-diversified portfolios for which ei 0 Arbitrage opportunities do not exist. We cannot achieve a certain positive return from zero investment (No free lunch) Short selling is allowed Comment: These assumptions are different from, weaker than, the assumptions needed for the CAPM

Arbitrage Pricing Theory

Rt Et bi1i bi 2i ... bik k i
For i = 1 to N where: Ri = return on asset i during a specified time period ei = expected return for asset I bik = reaction in asset is returns to movements in a common factor common k = areturns onfactor with a zero mean that influences the all assets i = a unique effect on asset is return that, by assumption, is completely diversifiable in large portfolios and has a mean of zero N = number of assets

Arbitrage Pricing Theory (APT)

bik measure how each asset (i) reacts to a common factor (k) Each asset may be affected by a factor, but the effects will differ In application of the theory, the factors are not identified Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio

Arbitrage Pricing Theory

Multiple factors expected to have an impact on all assets: Inflation Growth in GNP Major political upheavals Changes in interest rates And many more. Contrast with CAPM assumption that only beta is relevant

Arbitrage Pricing Theory (APT)

APT assumes that, in equilibrium, the return on a zero-investment, zerosystematic-risk portfolio is zero when the unique effects are diversified away The expected return on any asset i (Ei) can be expressed as:

Arbitrage Pricing Theory (APT)

Ei 0 1bi1 2bi 2 ... k bik

where: = the expected return on an asset with zero 0 systematic risk where 0 0 1 = the risk premium related to each of the common factors - for example the risk premium related to interest rate risk

bik = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor K

Example of Two Stocks and a Two-Factor Model

Example of Two Stocks (X and Y) and a Two-Factor Model

1 = changes in the rate of inflation. The risk premium related to

(1 .01)
related to this factor is 2 percent for every 1 percent change in the rate ( .02)

this factor is 1 percent for every 1 percent change in the rate

2= percent growth in real GNP. The average risk premium

2
rate of return on a 3= the b =0) is 3 percent zero-systematic-risk asset (zero beta:
oj

(3 .03)

Example of Two Stocks and a Two-Factor Model

The two assets (X,Y) have the following response coefficients to these factors:

bx1= the response of asset X to changes in the rate of

inflation is 0.50

(bx1 .50)

by1= the response of asset Y to changes in the rate of inflation

is 0.5

(by1 .50)

bx 2 = the response of asset X to changes in the growth rate of

real GNP is 1.50

(bx 2 1.50)

b y 2= the response of asset Y to changes in the growth rate of

real GNP is 1.75

(by 2 1.75)

Example of Two Stocks and a Two-Factor Model

Ei 0 1bi1 2bi 2
These response coefficients indicate that if these are the major factors influencing asset returns, asset Y is a higher-risk asset, and therefore its expected (required) return should be greater, as shown below:

= .03 + (.01)bi1 + (.02)bi2 Ex = .03 + (.01)(0.50) + (.02)(1.50) = .065 = 6.5% Ey = .03 + (.01)(2.00) + (.02)(1.75) = .085 = 8.5%

Example of Two Stocks and a Two-Factor Model

If the prices of the assets do not reflect these returns, we would expect investors to enter into arbitrage arrangements whereby they would sell overpriced assets short and use the proceeds to purchase the underpriced assets until the relevant prices were corrected.

Empirical Tests of the APT

Chen, Roll, and Ross (Journal of Finance 1986) considered the following five economic factors as candidates for explaining the return generating structure Of common stocks: 1. Monthly growth rate in U.S. industrial production 2. Changes in expected inflation 3. Unanticipated inflation 4. Unanticipated changes in default risk premium, measured as the difference between the return on a portfolio of corporate bonds rate BAA and under nd return on a portfolio of long-term U.S. government bonds. 5. Unanticipated changes in the slope of the term structure of interest rates, measured as the difference between the return on a portfolio of long-term U.S. government bonds and the one-month U.S. Treasury bill return, that is , the unanticipated return on long-term government bonds.

Empirical Tests of the APT

Reinganums study indicated that the APT does not explain small-firm results Dhrymes and Shanken question the usefulness of APT because it was not possible to identify the factors and therefore may not be testable

Burmeister and McElroy (1988 Financial Analyst Journal) suggested the following factors:

1. Unanticipated changes in the term structure (20-year Government bonds vs. Corporate 2. Unanticipated changes in bond default premiums (Government bonds vs. Corporate). 3. Unanticipated changes in inflation 4. Unanticipated changes in growth rate of corporate profits, and 5. Unanticipated changes in residual market risk.

APT and CAPM

APT applies to well diversified portfolios and not necessarily to individual stocks. With APT it is possible for some individual stocks to be mispriced - not lie on the SML. APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio. APT can be extended to multifactor models. There is no general agreement on what the factors should be included (see Chen, Ross and Roll (1986))

APT and CAPM

Both the CAPM and APT are risk-based models. Empirical methods are based less on theory and more on looking for some regularities in the historical record. Related to empirical methods is the practice of classifying portfolios by style, e.g.,
Value portfolio Growth portfolio