CHAPTER TWELVE

ARBITRAGE PRICING
THEORY
1

Background
Estimating expected return with the Asset
Pricing Models of Modern Finance
CAPM
Strong assumption - strong prediction

Corresponding Security
Market Line

Market Index on Efficient

Set
Expected
Return

B
C

Expecte
d
Return

Market
Index
A
x

Risk
(Return
Variability)

x
xx

x
xx

x
xx

x
x
x

x
xx

x
xx

Market
Beta

Market Index Inside

Efficient Set
Expected
Return

Corresponding Security
Market Cloud
Expecte
d
Return

Market
Index

Risk
(Return Variability)

Market Beta

FACTOR MODELS
ARBITRAGE PRICING THEORY (APT)
is an equilibrium factor model of security returns
Principle of Arbitrage
the earning of riskless profit by taking advantage of
differentiated pricing for the same physical asset or security

Arbitrage Portfolio
requires no additional investor funds
no factor sensitivity
has positive expected returns

Example
5

Curved Relationship Between Expected Return and Interest Rate Beta

Expected Return
35%

25%
C

-3

E F

15%

B
5%

-1

-5%

-15%

3
Interest Rate Beta

The Arbitrage Pricing Theory

Two stocks

A: E(r) = 4%;

Interest-rate beta = -2.20

B: E(r) = 26%; Interest-rate beta = 1.83

Invest 54.54% in E and 45.46% in A

Portfolio E(r) = .5454 * 26% + .4546 * 4% = 16%

Portfolio beta = .5454 * 1.83 + .4546 * -2.20 = 0

With many combinations like this, you can create a

risk-free portfolio with a 16% expected return.

The Arbitrage Pricing Theory

Two different stocks

C: E(r) = 15%; Interest-rate beta = -1.00

D: E(r) = 25%; Interest-rate beta = 1.00

Invest 50.00% in E and 50.00% in A

Portfolio E(r) = .5000 * 25% + .4546 * 15% = 20%

Portfolio beta = .5000 * 1.00 + .5000 * -1.00 = 0

With many combinations like this, you can create a riskfree portfolio with a 20% expected return. Then sell-short
the 16% and invest the proceeds in the 20% to arbitrage.

The Arbitrage Pricing Theory

No-arbitrage condition for asset pricing

If risk-return relationship is non-linear, you

can arbitrage.
Attempts to arbitrage will force linearity in
relationship between risk and return.

APT Relationship Between Expected Return and Interest Rate Beta

Expected Return
35%
E
25%

15%
C

5%

A B
-3

-1

-5%

-15%

3
Interest Rate Beta

FACTOR MODELS
ARBITRAGE PRICING THEORY (APT)
Three Major Assumptions:
capital markets are perfectly competitive
investors always prefer more to less wealth
price-generating process is a K factor model

11

FACTOR MODELS
MULTIPLE-FACTOR MODELS
FORMULA

ri = ai + bi1 F1 + bi2 F2 +. . .
+ biKF K+ ei
where r is the return on security i
b is the coefficient of the factor
F is the factor
e is the error term

12

FACTOR MODELS
SECURITY PRICING
FORMULA:

ri = 0 + 1 b1 + 2 b2 +. . .+ KbK
where
ri = rRF +(1rRFbi12rRF)bi2+

rRFbiK
13

FACTOR MODELS

where

is the return on security i

is the risk free rate

b
e

is the factor
is the error term

14

FACTOR MODELS
hence
a stocks expected return is equal to the risk
free rate plus k risk premiums based on the
stocks sensitivities to the k factors

15