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    Chapter 9 - Multifactor Models of Risk & Return

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    Imejah Favi
    The document summarizes the Arbitrage Pricing Theory (APT), an alternative multi-factor model for pricing assets and estimating returns. [1] The APT assumes asset returns can be predicted by macroeconomic factors rather than just the market portfolio. [2] It allows for multiple systematic risk factors like inflation and GDP growth rather than just one as in CAPM. [3] The APT provides a framework to estimate expected returns based on factor sensitivities and risk premia rather than relying on the single beta concept in CAPM.

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    Chapter 9 - Multifactor Models of Risk & Return

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    Imejah Favi
    44 views10 pages
    The document summarizes the Arbitrage Pricing Theory (APT), an alternative multi-factor model for pricing assets and estimating returns. [1] The APT assumes asset returns can be predicted by macroeconomic factors rather than just the market portfolio. [2] It allows for multiple systematic risk factors like inflation and GDP growth rather than just one as in CAPM. [3] The APT provides a framework to estimate expected returns based on factor sensitivities and risk premia rather than relying on the single beta concept in CAPM.

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    The document summarizes the Arbitrage Pricing Theory (APT), an alternative multi-factor model for pricing assets and estimating returns. [1] The APT assumes asset returns can be predicted by macroeconomic factors rather than just the market portfolio. [2] It allows for multiple systematic risk factors like inflation and GDP growth rather than just one as in CAPM. [3] The APT provides a framework to estimate expected returns based on factor sensitivities and risk premia rather than relying on the single beta concept in CAPM.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    44 views10 pages

    Chapter 9 - Multifactor Models of Risk & Return

    Uploaded by

    Imejah Favi
    The document summarizes the Arbitrage Pricing Theory (APT), an alternative multi-factor model for pricing assets and estimating returns. [1] The APT assumes asset returns can be predicted by macroeconomic factors rather than just the market portfolio. [2] It allows for multiple systematic risk factors like inflation and GDP growth rather than just one as in CAPM. [3] The APT provides a framework to estimate expected returns based on factor sensitivities and risk premia rather than relying on the single beta concept in CAPM.

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    © All Rights Reserved
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    of 10

    LCASTOL

    CHAPTER 9
    Multifactor Models of Risk and Return
    LEARNING OBJECTIVES

    Learning Objectives
    • Explain the deficiencies of the capital asset pricing model
    (CAPM)
    • Explain the arbitrage pricing theory (APT) and how it is
    similar and different from CAPM
    • Enumerate the strengths and weaknesses of the APT as a
    theory of how risk and expected return are related
    • Explain how can the APT be used in the security valuation
    process
    CRITICISMS OF CAPM
    Criticisms of CAPM
    • The many unrealistic assumptions
    • Information is freely available to investors
    • Investors have the same expectations and are risk
    averse
    • No taxes or transaction costs
    • Returns are normally distributed or investor’s utility
    is a quadratic function in returns
    • Investors can borrow or lend at the risk-free rate
    • One period model
    • 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)
    ARBITRAGE PRICING
    THEORY
    Definition
    Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can
    be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic
    variables that capture systematic risk
    Three Major Assumptions
    • Capital markets are perfectly competitive
    • Investors always prefer more wealth to less wealth with certainty
    • The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or
    indexes
    In contrast to CAPM, APT doesn’t assume
    • Normally distributed security returns
    • Quadratic utility function
    • A mean-variance efficient market portfolio
    ARBITRAGE PRICING
    THEORY
    The APT Model
    E(Ri)=λ0+ λ1bi1+ λ2bi2+…+ λkbik
    where:
    λ0= the expected return on an asset with zero systematic risk
    λj= the risk premium related to the j th common risk factor
    bij= the pricing relationship between the risk premium and the asset; that is,
    how responsive asset i is to the j th common factor

    The CAPM Model


    • In CAPM, the relationship is as follows:
    E(Ri)=RFR + βi[(E(RM-RFR)]

    9-5
    CAPM VS APT
    A Comparison with CAPM
    • Comparing CAPM and APT
    CAPM APT
    Form of Equation Linear Linear
    Number of Risk Factors 1 K(≥ 1)
    Factor Risk Premium [E(RM) – RFR] {λj}
    Factor Risk Sensitivity βi {bij}
    “Zero-Beta” Return RFR λ0

    • Unlike CAPM that is a one-factor model, APT is a multifactor pricing model


    • However, unlike CAPM that identifies the market portfolio return as the factor, APT model does not specifically
    identify these risk factors in application
    • These multiple factors include
     Inflation
     Growth in GNP
     Major political upheavals
     Changes in interest rates
    USING APT – AN EXAMPLE
    Selecting Risk Factors
    • As discussed earlier, the primary challenge with using the APT in security valuation is identifying the risk
    factors
    • For this illustration, assume that there are two common factors
     First risk factor: Unanticipated changes in the rate of inflation
     Second risk factor: Unexpected changes in the growth rate of real GDP
    Determining the Risk Premium
    • λ1: The risk premium related to the first risk factor is 2 percent for every 1 percent change in the rate (λ1=0.02)

    • λ2: The average risk premium related to the second risk factor is 3 percent for every 1 percent change in the rate of growth
    (λ2=0.03)

    • λ0: The rate of return on a zero-systematic risk asset (i.e., zero beta) is 4 percent (λ0=0.04)
    USING APT
    Determining the Sensitivities for Asset X and Asset Y
    • bx1 = The response of asset x to changes in the inflation factor is 0.50 (bx1 0.50)
    • bx2 = The response of asset x to changes in the GDP factor is 1.50 (bx2 1.50)
    • by1 = The response of asset y to changes in the inflation factor is 2.00 (by1 2.00)
    • by2 = The response of asset y to changes in the GDP factor is 1.75 (by2 1.75)

    Estimating the Expected Return


    • The APT Model
    E ( R i )   0  1bi1   2 bi 2

    = .04 + (.02)bi1 + (.03)bi2


    • Asset X
    E(Rx) = .04 + (.02)(0.50) + (.03)(1.50)
    = .095 = 9.5%
    • Asset Y
    E(Ry) = .04 + (.02)(2.00) + (.03)(1.75)
    = .1325 = 13.25%
    SECURITY VALUATION WITH THE APT AN
    EXAMPLES
    Three stocks (A, B, C) and two common systematic risk factors have the following relationship (Assume λ0=0 )

    E(RA)=(0.8) λ1 + (0.9) λ2

    E(RB)=(-0.2) λ1 + (1.3) λ2

    E(RC)=(1.8) λ1 + (0.5) λ2

    If λ1=4% and λ2=5%, then it is easy to compute the expected returns for the stocks:

    E(RA)=7.7%

    E(RB)=5.7%

    E(RC)=9.7%
    Expected Prices One Year Later
    • Assume that all three stocks are currently priced at $35 and do not pay a dividend
    • Estimate the price

    E(PA)=$35(1+7.7%)=$37.70

    E(PB)=$35(1+5.7%)=$37.00

    E(PC)=$35(1+9.7%)=$38.40
    MULTIFACTOR MODELS & RISK
    ESTIMATION
    The Multifactor Model in Theory
    • In a multifactor model, the investor chooses the exact number and identity of risk factors, while the
    APT model doesn’t specify either of them
    • The Equation
    Rit = ai + [bi1F1t + bi2 F2t + . . . + biK FKt] + eit

    where:
    Fit=Period t return to the jth designated risk factor

    Rit =Security i’s return that can be measured as either a nominal or excess return to

    The Multifactor Model in Practice


    • Macroeconomic-Based Risk Factor Models: Risk factors are viewed as macroeconomic in nature
    • Microeconomic-Based Risk Factor Models: Risk factors are viewed at a microeconomic level by
    focusing on relevant characteristics of the securities themselves,
    • Extensions of Characteristic-Based Risk Factor Models

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