Chapter 12

An Alternative View of Risk and Return:

The Arbitrage Pricing Theory

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Key Concepts and Skills
 Discuss the relative importance of systematic and
unsystematic risk in determining a portfolio’s return
 Compare and contrast the CAPM and Arbitrage

Pricing Theory

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Chapter Outline

12.1 Systematic Risk and Betas

12.2 Portfolios and Factor Models
12.3 Betas, Arbitrage, and Expected Returns
12.4 The Capital Asset Pricing Model and the Arbitrage
Pricing Theory
12.5 Empirical Approaches to Asset Pricing

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Arbitrage Pricing Theory

Arbitrage arises if an investor can construct a zero

investment portfolio with a sure profit.
◦ Since no investment is required, an investor can create large
positions to secure large levels of profit.
◦ In efficient markets, profitable arbitrage opportunities will
quickly disappear.

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Total Risk
 Total risk = systematic risk + unsystematic risk
 The standard deviation of returns is a measure of total

risk.
 For well-diversified portfolios, unsystematic risk is

very small.
 Consequently, the total risk for a diversified portfolio

is essentially equivalent to the systematic risk.

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 Risk: Systematic and Unsystematic
We can break down the total risk of holding a stock into
two components: systematic risk and unsystematic risk:
2
R  R U
Total risk
becomes
 R  R  m 
where
Nonsystematic Risk: 
m is the systematic risk
Systematic Risk: m  is the unsystematic risk

n
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12.1 Systematic Risk and Betas – I
 The beta coefficient, b, tells us the response of the stock’s
return to a systematic risk.
 In the CAPM, b measures the responsiveness of a security’s
return to a specific risk factor, the return on the market
portfolio.

Cov(Ri,RM )
i 
 (RM )
2

 We shall now consider other types of systematic risk.


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Systematic Risk and Betas – II
 For example, suppose we have identified three
systematic risks: inflation, GNP growth, and the
dollar-euro spot exchange rate, S($,€).
 Our model is:
R  R  m 
R  R  I FI  GNP FGNP  S FS  
I is the inflation beta
GNP is the GNP beta
S is the spot exchange rate beta
 is the unsystematic risk
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Systematic Risk and Betas: Example

R  R  I FI  GNP GNP  S FS  
 Suppose we have made the following estimates:
1. bI = -2.30
2. bGNP = 1.50

3. bS = 0.50
 Finally, the firm was able to attract a “superstar”
CEO, and this unanticipated development contributes
1% to the return.
R  R  2.30  FI 1.50  FGNP  0.50  FS 1%
ε  1%
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 Systematic Risk and Betas: Example - I

R  R  2.30  FI 1.50  FGNP  0.50  FS 1%

We must decide what surprises took place in the
systematic factors.
 If it were the case that the inflation rate was expected to
be 3%, but in fact was 8% during the time period, then:
FI = Surprise in the inflation rate = actual − expected
= 8% − 3% = 5%

R  R  2.30  5% 1.50  FGNP  0.50  FS 1%

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 Systematic Risk and Betas: Example - II

R  R  2.30  5% 1.50  FGNP  0.50  FS 1%

If it were the case that the rate of GNP growth was

expected to be 4%, but in fact was 1%, then:
 FGNP = Surprise in the rate of GNP growth
= actual – expected = 1% – 4% = – 3%

R  R  2.30  5% 1.50  (3%)  0.50  FS 1%

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
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 Systematic Risk and Betas: Example - III

R  R  2.30  5% 1.50  (3%)  0.50  FS 1%

If it were the case that the dollar-euro spot exchange

rate, S($,€), was expected to increase by 10%, but in
 fact remained stable during the time period, then:
FS = Surprise in the exchange rate
= actual − expected = 0% − 10% = − 10%

R  R  2.30  5%  1.50  (3%)  0.50  (10%) 1%

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Systematic Risk and Betas: Example - IV

R  R  2.30  5%  1.50  (3%)  0.50  (10%) 1%

Finally, if it were the case that the expected return on

the stock was 8%, then:

R  8%
R  8%  2.30  5% 1.50  (3%)  0.50  (10%) 1%
R  12%


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12.2 Portfolios and Factor Models
 Now let us consider what happens to portfolios of
stocks when each of the stocks follows a one-factor
model.
 We will create portfolios from a list of N stocks and

will capture the systematic risk with a 1-factor model.

 The ith stock in the list has return:

)  +

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Relationship Between the Return on the
Common Factor and Excess Return – I

Excess  
return
If we assume
that there is no
i unsystematic
risk, then ei = 0.

The return on the factor F

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Relationship Between the Return on the
Common Factor and Excess Return – II

Excess   If we assume
return that there is no
unsystematic
risk, then ei = 0.

The return on the factor F

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Relationship Between the Return on the
Common Factor and Excess Return – III

Excess
return β A  1 .5 β B  1 .0 Different
securities will
β C  0 .50 have different
betas.

The return on the factor F

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Portfolios and Diversification – I
 We know that the portfolio return is the weighted average of
the returns on the individual assets in the portfolio:
R  X R  X R 
P 1 1 2 2
…  X R 
i
…X R i N N

Ri  R i  i F   i
RP  X 1 ( R1  1F  1 )  X 2 ( R 2   2 F   2 ) 

… X N (RN  N F   N )

RP  X1 R1  X11F  X11  X 2 R 2  X 2 2 F  X 2 2 
... X N R N  X N N F  X N  N
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Portfolios and Diversification – II
The return on any portfolio is determined by three sets of
parameters:
1. The weighted average of expected returns.
2. The weighted average of the betas times the factor.
3. The weighted average of the unsystematic risks.

RP  X 1 R1  X 2 R 2  
…  X RN
N
 ( X 11  X 2  2  
…  X  )F
N N
 X 11  X 2 2  …  X 
N N
In a large portfolio, the third row of this equation
disappears as the unsystematic risk is diversified away.
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Portfolios and Diversification – III

So the return on a diversified portfolio is determined by

two sets of parameters:
1. The weighted average of expected returns.
2. The weighted average of the betas times the factor F.

RP  X 1 R1  X 2 R 2  
…  X N RN
 ( X 11  X 2  2  
…  X N  N )F

In a large portfolio, the only source of uncertainty is the

portfolio’s sensitivity to the factor.

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12.3 Betas, Arbitrage, and Expected
Returns

RP  X 1 R1  X 2 R 2  
…  X N RN
 ( X 11  X 2  2  
…  X N  N )F

The return on a diversified portfolio is the sum of the expected

return plus the sensitivity of the portfolio to the factor.

 
𝑅 𝑃 =E ( 𝑅 𝑃 )+ 𝛽 𝑃 𝐹

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Relationship Between b and Expected
Return – I
 If shareholders are ignoring unsystematic risk, only
the systematic risk of a stock can be related to its
expected return.
 Considering the market portfolio as our factor

produces:
 
]

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 Relationship Between b and Expected
Return – II

Expected return
SML

D
A
B
RF
C

E(R)
 
]
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12.4 The Capital Asset Pricing Model
and the 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 – i.e., 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.

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12.5 Empirical Approaches to Asset
Pricing
 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.
 Be aware that correlation does not imply causality.
 Related to empirical methods is the practice of

classifying portfolios by style, e.g.,

◦ Value portfolio
◦ Growth portfolio

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Quick Quiz
 Differentiate systematic risk from unsystematic risk.
Which type is essentially eliminated with well
diversified portfolios?
 Define arbitrage.
 Explain how the CAPM can be considered a special

case of Arbitrage Pricing Theory?

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