Corporate Finance

Lecture 9

Corporate Finance

Lecture 9 :
Arbitrage Pricing Theory
(APT)
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Arbitrage Pricing Theory (APT)

! An alternative approach to calculate equilibrium expected
returns on financial assets
! Based on the premise that efficient financial markets should be
arbitrage-free
! Using a factor model of asset returns, it implies restrictions
on the relationships between asset returns & generates an
equilibrium pricing relationship
! In other words, expected asset returns are exposed to a
common set of factors that must be mutually consistent, given
each asset s sensitivity to each other
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Corporate Finance

Lecture 9

Arbitrage Pricing Theory (APT)

! Two possible types of arbitrage strategies
!

Investment in a set of assets (buying & selling) that yields

an immediate positive net cash inflow & principal is
guaranteed

Investment that is costless but guarantees positive future

returns

For both strategies, any rationale investor would try to invest as

much as possible under APT
=> In efficient financial markets, such opportunities
should not arise
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APT : Single-Factor Models

! On the basis that the asset returns is generated by a factor
model, the one-factor model can be represented as follows :
R i = ! i + "i F + # i

where E (# i ) = 0

! Returns on asset i are related to 2 main components

! Factor F which will affect all asset returns depending on
each asset s sensitivity to factor F measured by i, a relative
risk measure

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Lecture 9

APT : Single-Factor Models

!

i is a random shock to returns which is also known as

idiosyncratic (distinctive or peculiar affecting only that
stock) return component for asset i is assumed to be
uncorrelated
Across different assets ie. Cov (i,j) = 0 for all i not = j
E.g. Departure of key personnel or unexpected legal
action
With the factor F ie. Cov (i,F) = 0 for all i

! Implication : All common variation in asset returns is generated

by movements in factor F as i being uncorrelated across assets,
do not bring about covariation in asset price movements
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Application Exercise from Subject Guide

Consider an economy where risk-free rate of return is 4% & the
expected market index rate of return is 9%. The market return
variance is 20%. Two portfolios A & B have expected return 7%
& 10% and variance 20% & 50% respecetively
! Work out the portfolios beta coefficients
! CAPM : Ri = Rf + i(Rm Rf)
! Therefore, i = (Ri Rf)/(Rm Rf)
! A = (7% - 4%)/(9% - 4%) = 0.6
! B = (10% - 4%)/(9% - 4%) = 1.2

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Lecture 9

Application Exercise from Subject Guide

! The risk of a portfolio can be decomposed into market &
idiosyncratic risks. What the proportions of market &
idiosyncratic risks for the two portfolios A & B?
! RA = A + ARm + A
! RB = B + BRm + B
! With Cov(Rm,A) = Cov(Rm,B) = 0
! A2 = Cov (RA,RA)
= Cov (A + ARm + A,A + ARm + A)
= Cov (ARm + A,ARm + A) where A is constant
= Cov (ARm,ARm) + Cov (ARm,A) + Cov (A,ARm)
+ A2
= A2m2 + A2
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Application Exercise from Subject Guide

!
!

B2 = B2m2 + B2
Proportion of Systematic Risk to Total Risk for
Portfolio A : A2m2/A2 = [(0.6)2 x 20%]/20% = 36%
Portfolio B : B2m2/B2 = [(1.2) 2 x 20%]/50% = 58%
Proportion of Idiosyncratic Risk to Total Risk for
Portfolio A : A2/A2 = 100% - 36% = 64%
Portfolio B : B2/B2 = 100% - 58% = 42%
Portfolio B is much riskier than Portfolio A primarily due to
higher sensitivity towards market return

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Lecture 9

Application Exercise from Subject Guide

! Assume the two portfolios have uncorrelated idiosyncratic risk.
What is the covariance between the returns on the two
portfolios?
! Cov (RA,RB) = Cov (A + ARm + A,B + BRm + B)
= Cov (ARm + A,BRm + B) where A & B are constant
= Cov (ARm,BRm) + Cov (ARm,B) + Cov (A,BRm)
+ Cov (A, B)
= ABm2 = 0.6 x 1.2 x 20% = 14%

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APT : Multi-Factor Models

! A generalisation of the structure with k factors that can affect
asset returns is
Ri = " i + #1i F1 + #2i F2 + .....+ #ki Fk + $i

()

where E $i = 0

! Assumptions
! The idiosyncratic component is not correlated across assets
& with all of the factors
! Each factor has a mean of 0
! The factors can represent news on economic conditions,
financial conditions, political events, oil prices, interest
rates, inflation rates etc
! Imply E(R i ) = " i
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Corporate Finance

Lecture 9

APT : Multi-Factor Models

! Each asset has a complement of factor sensitivities or factor
that determine how sensitive the return on the asset in question is
to the variations in each factor
! For portfolio of assets in a multi-factor model, the factor
sensitivities for a portfolio of assets are represented by the
portfolio weighted averages of the individual factor sensitivities
!
!
!

1p = wi1i where i = 1 to n assets for factor 1 of the portfolio

2p = wi2i where i = 1 to n assets for factor 2 of the portfolio
jp = wiji where i = 1 to n assets for factor j of the portfolio

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APT : Multi-Factor Models - Example

Rx = 0.05 + F1 " 0.05F2 + #x
Ry = 0.03 + 0.75F1 + 0.50F2 + #y
Rz = 0.04 " 0.25F1 " 0.30F2 + #z

To derive the factor structure of an equally weighted portfolio

!

1
(0.05 + 0.03+ 0.04) =0.04
3
1
"1p = (1+ 0.75 ! 0.25) = 0.50
3
1
"2p = (!0.05 + 0.50 ! 0.30 ) = 0.05
3

!p =

R p = ! p + "1p F1 + "2 p F2 + # p

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Corporate Finance

Lecture 9

APT : Multi-Factor Models - Example

Hence,
Rp = 0.04 + 0.50F1 + 0.05F2 + "p

where p is the idiosyncratic component in the portfolio return

!

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APT : Multi-Factor Models - Example

What if the portfolio weights for stocks x, y & z are 0.25, 0.50
& 0.75 respectively?

! p = (!0.25) ( 0.05) + ( 0.50 ) ( 0.03) + ( 0.75) ( 0.04) =0.0325

!1p = (!0.25) (1) + ( 0.50 ) ( 0.75) + ( 0.75) (!0.25) = ! 0.0625
!2p = (!0.25) (!0.05) + ( 0.50 ) ( 0.50 ) + ( 0.75) (!0.30 ) =0.0375
Rp = 0.0325 ! 0.0625F1 + 0.0375F2 + ! p

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Corporate Finance

Lecture 9

APT : Multi-Factor Models - Example

Implications
Can construct a portfolio of assets which has any desired set of
factor sensitivities through appropriate choice of the portfolio
weights
k-factor model will need k + 1 assets

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APT : Multi-Factor Models - Example

Using the same expressions for the asset x, y & z given earlier,
construct a portfolio of 3 assets with sensitivities of 0.50 & 1 on
the 1st & 2nd factor respectively
(Replicating an asset using the 3 assets)
Rp = p + 0.5F1 + 1F2 + p
Solve for Wx, Wy & Wz with the following 3 simultaneous
equations
Wx + 0.75Wy " 0.25Wz = 0.50
"0.05Wx + 0.50Wy " 0.30Wz = 1
where Wx + Wy + Wz = 1

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Corporate Finance

Lecture 9

APT : Factor Replicating Portfolios

! A factor-replicating portfolio is a portfolio with unit
exposure to one factor & zero exposure to all other factors
Ri = " i + #1i F1 + #2i F2 + .....+ #ki Fk + $i
where #1 = 1

# j = 0 for j = 2 to k

()

E $i = 0

! We assume that the basic securities used to replicate the

portfolios are themselves broad-based portfolios thus allowing
the losing of the idiosyncratic risk terms associated with the
!
securities ie. E(i) = 0
! The reason to construct factor-replicating portfolios is to build
a portfolio that has identical factor exposures to a given asset X
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APT : Factor Replicating Portfolios

! Assume a 2-factor model on 3 well diversified portfolios with
the following representations
R A = 0.03+ 0.1F1 ! 0.5F2
R B = 0.08 + 2F1 + F2
R C = 0.05 + 0.5F1 + 0.5F2

! Determine the portfolio weights (ie. WA, WB & WC) in order to

construct the 2 factor-replicating portfolios plus a portfolio
which has zero exposure to both factors (ie. Risk free
portfolio).
! What are the expected returns of the factor-replicating
portfolios & the risk-free portfolio?
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Corporate Finance

Lecture 9

APT : Factor Replicating Portfolios

! Construct Factor 1 Replicating Portfolio
! RF1 = 1 + 11F1 + 21F2 where 11 = 1 & 21 = 0
!11 = 0.1WA + 2WB + 0.5WC = 1
!21 = !0.5WA + WB + 0.5WC = 0
where WA + WB + WC = 1
!
!

Solve for WA, WB & WC then solve for 1

The solved factor-replicating portfolio is now
RF1 = 1 + F1
E(RF1) = 1 where 1 = 1 which is not risk-free
E(RF1) = Rf + 1 where 1 is the risk premium for F1
when 1= 1
1 = E(RF1) Rf = 1 - Rf
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APT : Factor Replicating Portfolios

! Construct Factor 2 Replicating Portfolio
! RF2 = 2 + 11F1 + 21F2 where 11 = 0 & 21 = 1
!11 = 0.1WA + 2WB + 0.5WC = 0
!21 = !0.5WA + WB + 0.5WC = 1
where WA + WB + WC = 1
!
!

Solve for WA, WB & WC then solve for 2

The solved factor-replicating portfolio is now
RF2 = 2 + F2
E(RF2) = 2 where 2 = 1 which is not risk-free
E(RF2) = Rf + 2 where 2 is the risk premium for F2
when 2= 1
2 = E(RF2) Rf = 2 - Rf
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Corporate Finance

Lecture 9

APT : Factor Replicating Portfolios

! Construct Risk-Free Replicating Portfolio
! RRF = RF + 11F1 + 21F2 where 11 = 0 & 21 = 0
!11 = 0.1WA + 2WB + 0.5WC = 0
!21 = !0.5WA + WB + 0.5WC = 0
where WA + WB + WC = 1
!
!

Solve for WA, WB & WC then solve for RF

The solved factor-replicating portfolio is now
RRF = RF
E(RRF) = RF where 1 = 2 = 0 which is risk-free
E(RRF) = Rf = RF
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APT : Factor Replicating Portfolios

Example
Assume a 2-factor model, construct a portfolio that replicate an
asset X with exposures of 0.75 to factor 1 & 0.3 to factor 2 using
the 2 factor replicating & risk-free portfolios
Solution
1p = W111 + W212 + WRF1RF = 0.75 = 1X
where 11 = 1, 12 = 0 & 1RF = 0 => W1 = 0.75
2p = W121 + W222 + WRF2RF = -0.3 = 2X
where 11 = 0, 12 = 1 & 2RF = 0 => W2 = -0.3
As W1 + W2 + W3 = 1 => W3 = 1 0.75 (-0.3) = 0.55
Asset X can be replicated with weightages of 0.75, -0.3 & 0.55
of the factor replicating & risk free portfolios
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Corporate Finance

Lecture 9

APT : Factor Replicating Portfolios

! In the absence of arbitrage, all assets with identical factor
exposures should earn the same return
! Derivation of expected return of replicating portfolio
! Rf : Risk-free rate
! Rf + i : Expected return on the ith factor-replicating
portfolio where i is the risk premium associated with the ith
factor
! RX = W1(Rf + 1) + W2(Rf + 2) + W3Rf
= W1(Rf + 1) + W2(Rf + 2) + (1 W1 W2)Rf
= [W11 + W22] + Rf
= Rf + Risk Premium
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APT : Factor Replicating Portfolios

!

Assumptions
Two-factor model
To replicate asset X, which has sensitivity 1x & 2x to
the 1st & 2nd factor respectively
The primary securities are well-diversified
=> Idiosyncratic risk is ignored
To replicate asset X s factor sensitivities, construct a
portfolio with
Weight of 1x on the 1st factor-replicating portfolio
Weight of 2x on the 2nd factor-replicating portfolio &
Resulting weight of (1 - 1x - 2x) on the risk-free asset
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Corporate Finance

Lecture 9

APT : Factor Replicating Portfolios

!

The expected return of the replicating portfolio is

represented by

( ) (
E (R ) = R + "

) (

E Rx = "1x Rf + #1 + "2x Rf + #2 + 1$ "1x $ "2x Rf

x

# + "2x #2

1x 1

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APT : Summary
! Basic assumptions
! Asset returns are generated by a 2-factor (or in general kfactor) model
! Arbitrage opportunities do not exist
! Portfolios formed are well diversified
! E(Rx) = Rf + [1x 1 + 2x 2] = Rf + Risk Premium
! Allows k sources of systematic risk including macroeconomic
factors (e.g. inflation & interest rate risk) & characteristics
specific to a firm s industry & sector
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