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ARBITRAGE PRICING
THEORY
1
Background
2
Market Index on Efficient Set Corresponding Security
Market Line
Expected Expected
B
Return Return
C
x x
x xx
Market x
x xx
Index x
x x
x
x xx
A x
x xx
x
x xx
Risk Market
(Return Variability) Beta
Market Index Inside Corresponding Security
Efficient Set Market Cloud
Expected Expected
Return Return
Market
Index
Expected Return
35%
E F
D
25%
C
15%
B
A
5%
-3 -1 -5% 1 3
Interest Rate Beta
-15%
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
9
APT Relationship Between Expected Return and Interest Rate Beta
Expected Return
35%
F
E
25% D
15%
C
5%
A B
-3 -1 -5% 1 3
Interest Rate Beta
-15%
FACTOR MODELS
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
12
e is the error term
FACTOR MODELS
• SECURITY PRICING
FORMULA:
ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK
where
ri = rRF +(d1-rRF )bi1 + (d2- rRF)bi2+ . . .
+(d-rRF)biK
13
FACTOR MODELS
14
FACTOR MODELS
• hence
– a stock’s expected return is equal to the risk
free rate plus k risk premiums based on the
stock’s sensitivities to the k factors
15