Investment Management

27521

Lecture 4
Factor Model and APT
Spring 2019

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• Main Questions:
– Is CAPM subject to any limitations?
– Is there other models that can be used?
– What is the Single Factor Model?
• Single index model (SIM)
• CAPM and SIM
• Applying the SIM
– Are there Multi-factor Models?
• Two-factor model; Fama and French Three-Factor Model; Chen, Roll
and Ross Multi-Factor Model.
– What is the Arbitrage Pricing Theory (APT)?
• Statistical Arbitrage
• Factor mimicking portfolios
• CAPM and APT

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 LIMITATIONS OF THE CAPM
• The CAPM has several limitations, such as:
1. It relies on a theoretical “market portfolio” that
includes all assets.
– Not all assets are traded.
– It can be computational infeasible to estimate variances
and covariance when there is a large number of assets.
• The number of variances and covariances that need to be
estimated are n(n+1) with n being the number of assets (see
lecture 3).
2. It uses expected returns not actual returns.

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 OTHER MODELS?
• A solution would be to write down a statistical model
that describes the relationship between asset returns
and the underlying risk factors. This will simplify the
estimation process.
– Factor models are statistical models that can do this. They
use actual portfolios whose return is unambiguous and
easy to measure.
– However, a fundamental question, of statistical models, is
how do they account for no-arbitrage opportunities in the
market?
– The Arbitrage Pricing Theory (APT) uses no-arbitrage
conditions as a basis for determining the structure of asset
returns.
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 SINGLE FACTOR MODEL
• Factor models assume that asset returns depend on
some common factors.
• A single factor model assumes all asset returns
depend on the systematic risk of one common factor.
– Changes in an asset’s return depend on this factor’s
systematic risk, as asset-specific effects are diversified away
in large portfolios.
– When the common factor is the market index it is called the
single index model (SIM). The SIM is the most common
single factor model.

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 Single Index Model (SIM)
• SIM uses realised excess returns not realised returns.
𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 (𝑟𝑚𝑡 −𝑟𝑓𝑡 ) + 𝜀𝑖𝑡
• where rit is the return on asset i in period t; rmt is the return on the
market index in period t; rft is the risk-free rate in period t; αi is the
intercept; βi is the slope and 𝜀𝑖𝑡 is the residual error that captures
the asset-specific effects in period t.
• The excess returns are (𝑟𝑖𝑡 −𝑟𝑓𝑡 ) and (𝑟𝑚𝑡 −𝑟𝑓𝑡 )
• This is very similar to a regression relationship
– If 𝑅𝑖 = excess return of asset 𝑖 and 𝑅𝑚 = excess return of
the market index, the equation can be rewritten as:
𝑅𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 + 𝜀𝑖𝑡
• This is often called a return generating process (RGP).
• 𝑅𝑚 is known as the risk premium of the market index.

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• The assumptions behind this equation are:
𝑅𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 + 𝜀𝑖𝑡
– E 𝜀𝑖,𝑡 = 0 for all 𝑖
– 𝐶𝑜𝑣 𝜀𝑖 , 𝜀𝑗 = 0 for 𝑖 ≠ 𝑗
– 𝐶𝑜𝑣 𝜀𝑖 , 𝑅𝑚 = 0 for all 𝑖
• Comparing SIM to CAPM
– The CAPM predicts that αi = 0
– αi is called “alpha”. A positive alpha (αi > 0) would imply an
asset’s return is higher than predicted by CAPM. A negative
alpha (αi < 0) implies the asset’s return is lower than
predicted by CAPM.
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• The CAPM is about expected return so we can rewrite
the SIM equation in terms of expected return.
𝐸[𝑅𝑖𝑡 ] = 𝛼𝑖 + 𝛽𝑖𝑚 𝐸[𝑅𝑚𝑡 ] for all 𝑖
• The residual error drops out as 𝐸 𝜀𝑖𝑡 = 0 for all 𝑖.
• Variance and covariance for the SIM are calculated as:
𝜎𝑖2 = 𝛽𝑖𝑚
2
𝜎𝑚2
+ 𝜎𝜀𝑖2
2
𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 = 𝜎𝑖𝑗 = 𝛽𝑖𝑚 𝛽𝑗𝑚 𝜎𝑚
2 =𝜎 /𝜎 2
𝛽𝑖𝑚 =𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑚 /𝜎𝑚 𝑖𝑚 𝑚
– This is a lot simpler than calculating the variance and
covariance for the CAPM!

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• The proofs for the variance/covariance are:
1. 𝜎𝑖2 = 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑖 = 𝐶𝑜𝑣 𝛼𝑖 , 𝛼𝑖 + 𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝛼𝑖 +
𝐶𝑜𝑣 𝜀𝑖 , 𝛼𝑖 +𝐶𝑜𝑣 𝛼𝑖 , 𝛽𝑖 𝑅𝑚 +𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝛽𝑖 𝑅𝑚 +
𝐶𝑜𝑣 𝜀𝑖 , 𝛽𝑖 𝑅𝑚 +𝐶𝑜𝑣 𝛼𝑖 , 𝜀𝑖 +𝐶𝑜𝑣 𝛼𝑖 , 𝛽𝑖 𝑅𝑚 +𝐶𝑜𝑣 𝜀𝑖 , 𝜀𝑗
= 𝛽𝑖2 𝜎𝑚
2
+ 𝜎𝜀𝑖2

2. 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 = 𝐶𝑜𝑣 𝛼𝑖 , 𝛼𝑗 + 𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝛼𝑗 +

𝐶𝑜𝑣 𝜀𝑖 , 𝛼𝑗 +𝐶𝑜𝑣 𝛼𝑖 , 𝛽𝑗 𝑅𝑚 +𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝛽𝑗 𝑅𝑚 +
𝐶𝑜𝑣 𝜀𝑖 , 𝛽𝑗 𝑅𝑚 +𝐶𝑜𝑣 𝛼𝑖 , 𝜀𝑗 +𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝜀𝑗 +𝐶𝑜𝑣 𝜀𝑖 , 𝜀𝑗
2
= 𝛽𝑖 𝛽𝑗 𝜎𝑚
3. 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑚 = 𝐶𝑜𝑣 𝛼𝑖 , 𝛽𝑖 𝑅𝑚 + 𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝑅𝑚 + 𝐶𝑜𝑣 𝜀𝑖 , 𝑅𝑚
2
= 𝛽𝑖 𝜎𝑚
This is because only 𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝛽𝑖 𝑅𝑚 , C𝑜𝑣 𝜀𝑖 , 𝜀𝑖 , 𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝛽𝑗 𝑅𝑚 and
𝐶𝑜𝑣 𝛽𝑖 𝑅𝑚 , 𝑅𝑚 do not equal zero.

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• Risk can be decomposed in the regression in the
same way as the CAPM regression:
𝜎𝑖𝑡2 = 𝛽𝑖𝑚
2 2
𝜎𝑚 + 𝜎𝜀𝑖2
Total risk (σ2i )= systematic risk ( β2im σ2m )
+ asset-specific risk σ2εi
(Note: Remember that asset-specific risk is also known as
unsystematic risk or idiosyncratic risk)
𝑅𝑖2 = Systematic risk/total risk
2 2
2 𝛽𝑖𝑚 𝜎𝑚 2
𝑅𝑖 = = 𝜌𝑖𝑚
𝜎𝑖2
where 𝜌𝑖𝑚 = 𝐶𝑜𝑟𝑟 𝑟𝑖𝑡 , 𝑟𝑚𝑡 .

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• Exercise – SIM calculations
– The index model for assets A and B are estimated from
excess returns. The results are:
𝑅𝐴 = 3% + 0.7𝑅𝑚 + 𝜀𝐴
𝑅𝐵 = −2% + 1.2𝑅𝑚 + 𝜀𝐵
𝜎𝑚 = 20%, 𝑅𝐴2 = 0.2, 𝑅𝐵2 = 0.12
– Calculate the following for assets A and B:
1. Their standard deviations.
2. Their systematic and asset-specific risk.
3. The correlation between Asset A and Asset B.
4. The covariance between the assets and the market
index.
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 2 2
𝛽𝑖𝑚 𝜎𝑚
1. Their standard deviations, 𝑅𝑖2 = so
𝜎𝑖2

2 2
2
𝛽 𝐴𝑚 𝜎𝑚
𝜎𝐴 = =
𝑅𝐴2
2 2
2
𝛽𝐵𝑚 𝜎𝑚
𝜎𝐵 = =
𝑅𝐵2
2. Their systematic and asset-specific risk, 𝜎𝑖2 = 𝛽𝑖𝑚
2 2
𝜎𝑚 + 𝜎𝜀𝑖2
2 2
𝛽𝐴𝑚 𝜎𝑚 =
2
𝜎𝜀𝐴 = 𝜎𝐴2 − 𝛽𝐴𝑚 2 2 =
𝜎𝑚
2 2 =
𝛽𝐵𝑚 𝜎𝑚
2
𝜎𝜀𝐵 = 𝜎𝐵2 − 𝛽𝐵𝑚 2 2 =
𝜎𝑚

3. The correlation between Asset A and Asset B,

2 and 𝜌 = 𝜎𝑖𝑗
𝜎𝑖𝑗 = 𝛽𝑖 𝛽𝑗 𝜎𝑚 𝑖𝑗 𝜎𝜎 𝑖 𝑗
𝜎𝐴𝐵 =
𝜌𝐴𝐵 =
2
4. The covariance between the assets and the market index, 𝜎𝑖𝑚 = 𝛽𝑖 𝜎𝑚
𝜎𝐴𝑚 =
𝜎𝐵𝑚 =
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 2 2
𝛽𝑖𝑚 𝜎𝑚
1. Their standard deviations, 𝑅𝑖2 = so
𝜎𝑖2
2 2
2 𝛽𝐴𝑚 𝜎𝑚 0.72 ×0.22 0.0196
𝜎𝐴 = 2 = = = 0.098 and 𝜎𝐴 = 0.313
𝑅𝐴 0.2 0.2
2 2
2 𝛽𝐵𝑚 𝜎𝑚 1.22 ×0.22 0.0576
𝜎𝐵 = 2 = = = 0.48 and 𝜎𝐴 = 0.693
𝑅𝐵 0.12 0.12
2. Their systematic and asset-specific risk, 𝜎𝑖2 = 𝛽𝑖𝑚 2 2
𝜎𝑚 + 𝜎𝜀𝑖2
2 2 = 0.72 × 0.22 = 0.0196
𝛽𝐴𝑚 𝜎𝑚
2
𝜎𝜀𝐴 = 𝜎𝐴2 − 𝛽𝐴𝑚 2
𝜎𝑚2 = 0.098 − 0.0196 = 0.0784
2 2 = 1.22 × 0.22 = 0.0576
𝛽𝐵𝑚 𝜎𝑚
2
𝜎𝜀𝐵 = 𝜎𝐵2 − 𝛽𝐵𝑚 2
𝜎𝑚2 = 0.48 − 0.0576 = 0.4224

3. The correlation between Asset A and Asset B,

2 𝜎𝑖𝑗
𝜎𝑖𝑗 = 𝛽𝑖 𝛽𝑗 𝜎𝑚 and 𝜌𝑖𝑗 =
𝜎𝑖 𝜎𝑗
𝜎𝐴𝐵 = 0.7 × 1.2 × 0.22 = 0.0336
0.0336
𝜌𝐴𝐵 = = 0.1549
0.313 × 0.693
4. 2
The covariance between the assets and the market index, 𝜎𝑖𝑚 = 𝛽𝑖 𝜎𝑚
𝜎𝐴𝑚 = 0.7 × 0.22 = 0.028
𝜎𝐵𝑚 = 1.2 × 0.22 = 0.048

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• Exercise – Asset specific risk (idiosyncratic risk)
1. What would be the idiosyncratic risk, 𝜎𝜀𝑖2 , on an ASX200 index
exchange traded fund (ETF)?

2. Would the idiosyncratic risk for an individual share, say CBA,

be higher or lower than the idiosyncratic risk of an ASX200
index exchange traded fund?

3. What should happen to the beta and idiosyncratic risk of a

portfolio as it becomes more and more diversified?

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• Exercise – Asset specific risk (idiosyncratic risk)
1. What would be the idiosyncratic risk, 𝜎𝜀𝑖2 , on an ASX200 index
exchange traded fund (ETF)?
– The idiosyncratic risk would be very small as the ETF is very
diversified.
2. Would the idiosyncratic risk for an individual share, say CBA,
be higher or lower than the idiosyncratic risk of an ASX200
index exchange traded fund.
– CBA would have more idiosyncratic risk as it is an individual stock.
3. What should happen to the beta and idiosyncratic risk of a
portfolio as it becomes more and more diversified?
– Idiosyncratic risk will go to zero, however beta might stay
unchanged.
– A well-diversified portfolio is NOT risk-free as its beta will not be
zero.
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 CAPM and SIM
• The CAPM and SIM are not the same!
– The CAPM is focussed on expected (average) future
returns, the SIM is focussed on realised (actual or
observable) past returns.
– The CAPM is an equilibrium model while SIM is a statistical
model.
– SIM applications and CAPM tests use the same regression
relationship (same betas); but, their interpretations differ
• The SIM beta tells us how sensitive the stock return are to changes
in market returns. The CAPM beta tells us how much of a return
premium to expect. The SIM beta cannot be used to explain the risk
premium on an asset.
• Remember that the SIM assumes there is a single common risk
factor, which drives the returns of all risky securities, this common
risk factor is assumed to be the return of the market portfolio.
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 Applying the SIM
• You can estimate a regression equation to find beta,
alpha and the variance of the firm-specific risk.
– Pages 151 to 157 of the textbook provide a detailed
description on how to do this and interpret the regression
results.
• An example: Regress the monthly excess returns on
National Australia Bank (NAB) shares (RNAB) on the
monthly excess returns on the ASX200 index (RASX200).
– The ASX200 index is the proxy for the market index.
– The RBA’s cash rate was used as the risk-free rate.
RNAB = αNAB + βNABRASX200 + 𝜀NAB

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SUMMARY OUTPUT NAB R-squared indicates that about 53%
of the variation in NAB monthly
Regression Statistics returns is due to market returns
Multiple R 0.728615895 (systematic)
R Square 0.530881122
Alpha = 0.0075 but the t-statistic and p-value shows
Adjusted R Square 0.52355114
that it is statistically insignificant (indistinguishable
Standard Error 0.047848168
from zero)
Observations 66

ANOVA Beta = 1.077 and

df SS MS F Significance F statistically
Regression 1 0.165815442 0.165815442 72.42597438 4.07446E-12 significant (i.e.,
Residual 64 0.146524618 0.002289447 different from zero)
Total 65 0.31234006

Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 0.007527866 0.005955437 1.264032563 0.210802826 -0.004369487 0.019425219 -0.004369487 0.019425219
X Variable 1 1.077447371 0.126604427 8.510345139 4.07446E-12 0.824525953 1.33036879 0.824525953 1.33036879
You want a low standard error, a high t-value (higher than 2), and a low p-value to
indicate the significance of the variable.
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 Line of best fit between the X and Y variables
0.2

0.15 X variable = RNAB

0.1 Y variable = RASX200
0.05

0 Y
Y

-0.15 -0.1 -0.05 0 0.05 0.1 Predicted Y

-0.05

-0.1

-0.15 Plot of residual for the X variable

0.15
-0.2
X Variable 1

0.1

0.05

0
Residuals

-0.15 -0.1 -0.05 0 0.05 0.1

-0.05

-0.1

-0.15

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X Variable 1
• Some questions:
1. What does NAB’s beta (β) say about its systematic risk?

2. Interpret the alpha (α).

3. Based on the regression, what would be the expected return

on NAB next month if the market risk premium is at 0.8%
(monthly) and the RBA cash rate is 0.2% (monthly)?

• What if we expect the alpha to persist vs not persist?

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• Some questions:
1. What does NAB’s beta (β) say about its systematic risk?
• NAB’s beta is close to one so its systematic risk is about the
same as the market risk.
2. Interpret the alpha (α).
• α is close to 0 and not statistically significant. So all the
expected return can be explained by systematic risk.
3. Based on the regression, what would be the expected return
on NAB next month if the market risk premium is at 0.8%
(monthly) and the RBA cash rate is 0.2% (monthly)?
𝒓𝑵𝑨𝑩 = 𝟎. 𝟐 + 𝟎. 𝟖 = 𝟏. 𝟎%
• What if we expect the alpha to persist vs not persist?
– You would expect alpha to be arbitraged away so it cannot
persist.

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 MULTIFACTOR MODELS
• In the single-index model (SIM) the only source of
systematic risk is the market portfolio.
– The market portfolio’s systematic risk with the asset is
meant to reflect the average impact of macroeconomic
factors on an asset’s return.
– In real life this might not be the case and there could be
multiple sources of systematic risk.
• Multi-factor models extend the SIM to include more
than one factor.
– The factors need to be a source of systematic risk and have
their own risk premium. Some examples are:
• Excess returns on the market portfolio
• Unanticipated inflation
• Unanticipated changes in the level of industrial production
• Unanticipated changes in interest rates
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 Two-factor Model
• Assume there are two systematic factors, a
market portfolio and a treasury bond portfolio.
𝑅𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 + 𝛽𝑖𝑇𝐵 𝑅𝑇𝐵𝑡 + 𝜀𝑖𝑡
– where 𝑅𝑚𝑡 and 𝑅𝑇𝐵𝑡 are the excess return (risk
premium) on the two factors. 𝛽𝑚𝑡 and 𝛽𝑇𝐵𝑡 are the
sensitivities of the asset’s excess return to the factors.
• The expected return on asset “i” will be:
𝐸(𝑟𝑖 ) = 𝑟𝑓 + 𝛽𝑖𝑚 [𝐸(𝑟𝑚 ) − 𝑟𝑓 ] + 𝛽𝑖𝑇𝐵 [𝐸(𝑟𝑇𝐵 ) − 𝑟𝑓 ]
– This is the equation for a two-factor security market
line for security “i”.

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 Fama-French Three-Factor Model
• Fama and French selected factors that have a past
association with returns and are anomalies. The
anomalies being:
– Size (market capitalization): small shares typically earn higher
average returns than large shares,
– Value (book value to market value (B/M) of equity ratio): value
shares tend to earn higher average returns than growth shares.
𝑟𝑖 − 𝑟𝑓 = 𝛼𝑖 + 𝛽𝑖𝑚 [𝑟𝑚 −𝑟𝑓 ] + 𝛽𝑖𝐻𝑀𝐿 𝑟𝐻𝑀𝐿 + 𝛽𝑆𝑀𝐵 𝑟𝑆𝑀𝐵
• HML = returns on high B/M shares minus returns on low B/M shares.
– The HML return is generated by a long position in higher book-to-market
shares financed by a short position in low book-to-market shares.
• SMB – returns on small shares minus returns on big shares.
– The SMB return is generated by a long position in small company shares
financed by a short position in large company shares.

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 Chen, Roll, Ross Multi-Factor Model
• This model selected six risk factors that most
investors required a meaningful risk premium to
cover.
1. Return on market index (the NYSE stock index)
2. Change in industrial production
3. Change in expected inflation
4. Unexpected inflation
5. Excess return of long-term corporate bond over long-term
default free government bonds (i.e. the credit spread)
6. Excess return of long-term government bond over short-
term government bonds (i.e. the term premium)

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 N factors
• The 𝑁 factor model can be written as:

𝑟𝑖 = 𝑎𝑖 + 𝛽𝑖,1 𝐹1 + 𝛽𝑖,2 𝐹2 + 𝛽𝑖,3 𝐹3 + ⋯ + 𝛽𝑖,𝑁 𝐹𝑁 + 𝜀𝑖

𝑁

𝑟𝑖 = 𝑎𝑖 + 𝛽𝑖,𝑘 𝐹𝑘 + 𝜀𝑖
𝑘=1

– The betas are also known as factor loadings or sensitivities.

– These are realised returns, being driven by factors
• The time subscripts are not included in the above equations for
convenience.
• The assumptions behind this equation extend the ones on the SIM to
cover all the factors. 25721 Investment Management 26
 ARBITRAGE PRICING THEORY (APT)
• Assets are mispriced if they do not have a zero alpha.
Arbitrage trading will exploit mispricing by buying an
underpriced asset financed by short selling an overpriced
asset.
• In 1976 Stephen Ross developed a risk-return relationship
(i.e. rates of return versus risk premium) that would exist
in a well-functioning capital market were there is no
opportunity for arbitrage. It is known as the arbitrage
pricing theory (APT).
– The no-arbitrage condition provides a structure for asset prices.
– APT assumes that only a few systematic factors affect the long-
run average return on assets. So it only focuses on the major
forces moving asset returns in large portfolios.

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 Statistical Arbitrage
• A simple example of arbitrage trading.
𝑅𝐴 = 3% + 0.7𝑅𝑚 + 𝜀𝐴
𝑅𝐵 = −2% + 1.2𝑅𝑚 + 𝜀𝐵
• In the above equations, Asset A has a positive alpha while Asset B’s
alpha is negative. This means:
– A’s excess return is higher than predicted by the CAPM so it is
underpriced. It would be profitable to buy A. This would push up
A’s price and decrease A’s return until it lay on the SML.
– B’s excess return is lower than predicted by the CAPM so it is
overpriced. It would be profitable to sell B. This would push
down B’s price and increase B’s return until it lay on the SML.
– This mispricing can be exploited by buying A and selling B to
create portfolio, "𝑞”. Portfolio “q” is free from systematic risk.

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• Portfolio “q” will have no systematic risk so its beta is zero. Consequently,
the sum of the weighted asset’s betas must equal zero.
𝛽𝑞 = 𝑤𝐴 𝛽𝐴 + 𝑤𝐵 𝛽𝐵 = 0
Note: 𝑤𝐴 + 𝑤𝐵 = 1
• Using these two equations we can solve the weights:
−𝛽𝐵 𝛽𝐴
𝑤𝐴 = & 𝑤𝐵 =
𝛽𝐴 − 𝛽𝐵 𝛽𝐴 − 𝛽𝐵
• The excess return is 𝑅𝑞 = 𝑤𝐴 𝛼𝐴 + 𝑤𝐵 𝛼𝐵 + 𝑤𝐴 𝜀𝐴 + 𝑤𝐵 𝜀𝐵
– If A and B are well diversified portfolios then 𝜀𝐴 → 0 & 𝜀𝐵 → 0,

so 𝑅𝑞 = 𝑤𝐴 𝛼𝐴 + 𝑤𝐵 𝛼𝐵
– If 𝛼𝐴 > 𝛼𝐵 we expect a positive excess return and the statistical arbitrage becomes
a real arbitrage.

– Arbitrage should not exist in a well-functioning model.

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• Calculating the weights from the equations for A and B:
−1.2 0.7
• 𝛽𝑞 = 0 so 𝑤𝐴 = = 2.4 and 𝑤𝐵 = = −1.4
0.7−1.2 𝟎.𝟕−1.2

• Assuming A and B are well diversified portfolios and not assets:

𝑅𝑞 = 2.4 3% − 1.4 −2% = 10%
– The portfolio will generate an excess return of 10% with zero risk.
– The weight on A is 240% and the weight on B is -140%. However, the
sale of B will not generate enough cash to buy enough of A.
– So you need to borrow $1 at the risk-free rate and sell $1.4 of B to buy
$2.4 of A. The return on the investment will be 10% + risk-free rate.
After you repay the loan at the risk-free rate, the statistical arbitrage
profit will be 10%.
• This arbitrage trading will change the prices of A and B until the expected
returns of A and B are on the SML. At this point the market should be in
equilibrium and stable.

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 Factor Mimicking Portfolios
• In equilibrium the APT says the expected return of a
portfolio (or asset) will be:

E 𝑟𝑝 = 𝑟𝑓 + σ𝑁 ሚ
𝑘=1 𝛽𝑝𝑘 𝐸 𝑓𝑘 − 𝑟𝑓

– 𝑓ሚ𝑘 is a “factor mimicking portfolio” that has a 𝛽𝑘 = 1.

– Factor mimicking portfolios are “pure” measures of exposure
to each risk factor.
• The betas (𝛽𝑝𝑘 ) give us the amount of each risk in the portfolio
• 𝐸 𝑓ሚ𝑘 − 𝑟𝑓 gives the price of each risk, i.e., the return premium for
bearing a unit of that risk.

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• Factor mimicking portfolios will lie on the SML.
– An arbitrage opportunity exists if an asset/portfolio’s
expected return does not lie on the SML
Exp
Return

𝐸 𝑓ሚ1

𝑅𝑓 𝑎𝑟𝑏𝑖𝑡𝑟𝑎𝑔𝑒 Factor-Mimicking
Portfolio
𝐸 𝑅𝑖

𝛽𝑖1 = 0.45 𝛽1 = 1 Factor

Beta
A potential strategy: Sell the overpriced asset, buy the
market portfolio and invest in the risk-free asset.
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 CAPM vs APT
• The CAPM derivation relies on
– assumptions regarding investor preferences/beliefs (i.e.
quadratic utility functions and mean variance optimisers)
and asset return distributions.
– APT does not have these limiting assumptions.
• The APT assumes
– Markets exploit ‘arbitrage’ opportunities.
• This forces alphas to zero, and makes expected returns proportional
to betas (sensitivities to risky factors).
– Asset (portfolio) returns are determined by several risky
factors.
• However, it does not specify what the factors should be.
– A sufficiently large number of assets exist so that
idiosyncratic risk can be diversified away.
• This only works on a large well diversified portfolio.
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 Final Points
• Please do the tutorial questions and readings for this
lecture.
• Next week we will review the asset pricing models,
discuss the efficient market hypothesis (EMH),
consider the Grossman-Stiglitz paradox, test the
forms of EMH, and look at behavioural finance.
• If you have any problems. Please email your lecturer
or book in for a consultation.

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 Some of the formulae covered
𝑟𝑖𝑡 − 𝑟𝑓𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 (𝑟𝑚𝑡 −𝑟𝑓𝑡 ) + 𝜀𝑖𝑡
𝑅𝑖𝑡 = 𝛼𝑖 + 𝛽𝑖𝑚 𝑅𝑚𝑡 + 𝜀𝑖𝑡
𝐸[𝑅𝑖𝑡 ] = 𝛼𝑖 + 𝛽𝑖𝑚 𝐸[𝑅𝑚𝑡 ] for all 𝑖
𝜎𝑖2 = 𝛽𝑖𝑚2 2 + 𝜎2
𝜎𝑚 𝜀𝑖
2
𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 = 𝜎𝑖𝑚 = 𝛽𝑖𝑚 𝛽𝑗𝑚 𝜎𝑚
2 =𝜎 /𝜎 2
𝛽𝑖𝑚 =𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑚 /𝜎𝑚 𝑖𝑚 𝑚
𝜎𝑖𝑡2 = 𝛽𝑖𝑚
2 2 + 𝜎2
𝜎𝑚 𝜀𝑖
2 2
𝛽𝑖𝑚 𝜎𝑚
𝑅𝑖2 = 2
= 𝜌𝑖𝑚
𝜎𝑖2
𝜌𝑖𝑚 = 𝐶𝑜𝑟𝑟 𝑟𝑖𝑡 , 𝑟𝑚𝑡
𝑟𝑖 − 𝑟𝑓 = 𝛼𝑖 + 𝛽𝑖𝑚 [𝑟𝑚 −𝑟𝑓 ] + 𝛽𝑖𝐻𝑀𝐿 𝑟𝐻𝑀𝐿 + 𝛽𝑆𝑀𝐵 𝑟𝑆𝑀𝐵

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 𝑟𝑖 = 𝑎𝑖 + 𝛽𝑖,1 𝐹1 + 𝛽𝑖,2 𝐹2 + 𝛽𝑖,3 𝐹3 + ⋯ + 𝛽𝑖,𝑁 𝐹𝑁 + 𝜀𝑖
𝑁

𝑟𝑖 = 𝑎𝑖 + 𝛽𝑖,𝑘 𝐹𝑘 + 𝜀𝑖
𝑘=1

𝛽𝑞 = 𝑤𝐴 𝛽𝐴 + 𝑤𝐵 𝛽𝐵 = 0

−𝛽𝐵 𝛽𝐴
𝑤𝐴 = & 𝑤𝐵 =
𝛽𝐴 − 𝛽𝐵 𝛽𝐴 − 𝛽𝐵

𝑅𝑞 = 𝑤𝐴 𝛼𝐴 + 𝑤𝐵 𝛼𝐵 + 𝑤𝐴 𝜀𝐴 + 𝑤𝐵 𝜀𝐵

E 𝑟𝑝 = 𝑟𝑓 + σ𝑁 ሚ
𝑘=1 𝛽𝑝𝑘 𝐸 𝑓𝑘 − 𝑟𝑓
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