Keele Management School ECO-20044

Spring 2009

Appendix to Lecture notes 5 (APT)

Worked Example
5.1 The Market Asset returns are governed by a two-factor APT model; factor f1
represents domestic risk and factor f2 represents export risk. Both factors have zero
mean. Returns on three widely-diversified portfolios L, M and N satisfy the three
factor-price equations:

rL = 8.0 + 1.75f1 + 0.25f2; rM = 10.0 + 0.75f1 + 1.0f2; rN = 9.0 + 1.0f1 + 0.5f2;

where fi is the random factor i (i = 1; 2), and rj is the random rate of return of portfolio
j (j = L; M; N); fi and rj are given in per cent. The risk-free rate of return on
government bonds G is rf = 6%.

5.2 The Task We set ourselves the following task:

(i) From bond G and portfolios L and M, find the two factor prices λ1 and λ2.
(ii) Hence identify a risk-free arbitrage portfolio involving L, M and N.
Determine the appropriate correction in the rate of return of N that would eliminate
the arbitrage opportunity from (ii)
We shall solve this task step by step, beginning with the computation of the lambdas.

5.3 The Lambdas To find the two lambdas, we relate the factor loadings of portfolios
L and M to the risk premia of these porfolios. Since the factors f1 and f2 have zero
mean, expected returns of a portfolio are given by the constant term in the factor-
price equation:

E[rL] = 8.0; E[rM] = 10.0; E[rN] = 9.0:

The riskfree rate is rg = 6. Thus risk premia are:

r*L = 2.0; r*M = 4.0; r*N = 3.0:

Factor loadings for L and M are β1L =1.75, β2L = 0.25, β1M = 0.75, β2M = 1.0, To
determine the lambdas, we form the (APT) equations:

1.75λ1 + 0.25λ 2 = 2.0 (1)

0.75λ1 + 1.00λ 2 = 4.0 (2)

Solution: λ1 = 0.64, λ2 =3.52; the price of export risk is 5.5 times as high as the price
of domestic risk.

5.4 Eqilibrium Rate of Return To check for arbitrage, we first assess portfolio N’s
equilibrium risk premium by evaluating N’s factor loadings β1N = 1.0, β2N = 0.5, by the
corresponding lambdas:

rN*,Eql . = 1.0 × 0.64 + 0.5 × 3.52 = 2.4 (3)

In equilibrium, N must earn a risk premium of 2.4 per cent. But currently N earns a
risk premium of 3 per cent. Thus, N over-performs and is under-priced. For arbitrage,

1
we should buy N and finance our purchase by short-selling a replicating mixture of L,
M and G.

5.5 Arbitrage Portfolio To determine a specific arbitrage portfolio, we need to

replicate N’s with factor loadings β1N = 1.0 and β2N = 0.5 by a portfolio P of L, M and
bond G. Let wL, wM, wG be the weights of L, M and G in P. We want to form a portfolio
P whose overall factor loadings mimic those of N. The factor loadings of P are a
weighted average of the factor loadings of L and M. Thus:
1.75wL + 0.75wM = 1.00 (a)
0.25wL + 1.00wM = 0.50 (b)
Solution: wL = 0.4, wM = 0.4. Thus, for every pound earned from selling N, invest 40
pence in L and 40 pence in M; this will eliminate the influence of the two factors on
the overall portfolio returns. The remaining 20 pence (20%) are spent on G.
Thus, our replicating portfolio P has weights wL = 40 per cent (spent), wM = 40
per cent (spent), wG = 20 per cent (spent). This portfolio exactly mimics N’s factor
loadings, but has a lower expected rate of return E[rP]:

[ ]
E [rP ] = wL E [rL ] + wM E [rM ] + wG E r f = 0.4 × 8.0 + 0.4 × 10.0 + 0.2 × 6.0 = 8.4

as predicted by the APT pricing in eqn (3) above, where we found that N’s risk
premium should be 2.4.

For arbitrage, we need to short-sell P and buy N. Thus, we form an arbitrage

portfolio H with the following weights: vL = - 40 per cent (sell), vM = - 40 per cent
(sell), vG = - 20 per cent (sell), and vN = +100 per cent (buy). This portfolio costs
nothing. How much will it earn?
rH = −0.4 × rL − 0.4 × rM − 0.2 × r f + 1.0 × rN (4)

Substituting the factor-price equations into (4) yields:

rH = −0.4 × (8.0 + 1.75 f1 + 0.25 f 2 ) − 0.4 × (10.0 + 0.75 f 1 + 1.0 f 2 ) −

(5)
− 0.2 × 6.0 + 1.0 × (9.0 + 1.0 f 1 + 0.5 f 2 ).
In (5), expand all brackets and collect equal terms (do this in detail on paper!); you
find that all the f-terms cancel each other out and (5) reduces to:

rH = 0.6 ,
a positive and riskfree rate of return of 0.6 per cent on every pound raised by short-
selling portfolio P. Portfolio H is entirely self-financing; it costs us nothing — and yet it
earns a positive and risk-free profit. This is arbitrage.

5.6 Adjustment to Arbitrage: Equilibrium To exploit the arbitrage opportunity from

5.5, investors will wish to purchase unlimited amounts of N. This will push up the
price of N and thus reduce N’s expected rate of return to levels below the current 9
per cent. By reducing N’s expected rate of return from 9 to 8.4 per cent, the market
will eliminate the arbitrage profit associated with portfolio H. This confirms our
findings on the equilibrium risk premium from Section 5.4