Arbitrage Pricing Theory and Multifactor

Models of Risk and Return

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Arbitrage Pricing Theory (APT)

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Assumptions of Arbitrage Pricing

Theory (APT)
• 1. Unsystematic risk can be diversified away in a
portfolio.
• 2. Returns are generated using a factor model. The
APT provides little practical guidance for the
identification of the risk factors.
• 3. No arbitrage opportunities exist. This assumption
implies that investors will undertake infinitely large
positions (long and short) to exploit any perceived
mispricing, causing asset prices to adjust
immediately to their equilibrium values.
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Assumptions of Arbitrage Pricing

Theory (APT)
• EXAMPLE: Exploiting an arbitrage opportunity
• Suppose your investment firm uses a single-factor model
to evaluate assets. Consider the following data for
portfolios A, B, and C:

• Calculate the arbitrage opportunity from

the data provided.
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Wb = (Cbeta – Abeta)
(Bbeta – Abeta)

Wa = 1- Wb

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Assumptions of Arbitrage Pricing

Theory (APT)
• Answer:
• By allocating 50% of our funds to portfolio A and
50% to portfolio B, we can obtain a portfolio (D)
with beta equal to the portfolio C beta (1.5):
• Beta for portfolio D = 0.5(1) + 0.5(2) = 1.5
• While the betas for portfolios D and C are
identical, the expected returns are different:
• Expected return for portfolio D = 0.5(0.10) +
0.5(0.20) = 0.15 = 15%

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Assumptions of Arbitrage Pricing

Theory (APT)
• Answer:
• Therefore, we have created portfolio D that has
the same risk as portfolio C (beta = 1.5) but has
a higher expected return than portfolio C (15%
versus 13%).
• By purchasing portfolio D and short-selling
portfolio C, we expect to earn a 2% return (15%
minus 13%).

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Assumptions of Arbitrage Pricing

Theory (APT)
• An arbitrage opportunity is defined as an
investment opportunity that bears no risk and
no cost, but provides a profit.

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Arbitrage Pricing Theory

The law of one price
• If two assets are equivalent in all
economically relevant respects, then they
should have the same market price

• The law of one price is in force by

arbitrageurs, if they observe a violation of
the law they will engage in arbitrage
activity until the arbitrage opportunity is
eliminated
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Arbitrage Pricing Theory

The law of one price
• So how to do arbitrage?
• Buy at the lower-price market, then sell at
the higher-price market

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Arbitrage Pricing Theory

The law of one price
• In a very liquid and active markets ; the
buy and sell process can be done
simultaneously
• It has zero risk since you are long and
short the same amount of asset
• That is why you can borrow at risk free
rate

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Arbitrage Pricing Theory

• An arbitrage Since no
opportunity arises investment is
when an investor can required, investors
earn riskless profits
without making a net
will create large
investment positions to obtain
large profits.

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Arbitrage Pricing Theory

• Regardless of • In efficient
wealth or risk markets, profitable
aversion, investors arbitrage
will want an infinite opportunities will
position in the risk- quickly disappear.
free arbitrage
portfolio.

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Arbitrage Pricing Theory

• Meaning : Arbitrageurs will keep the law of

one price always, active and any
mispricing will be eliminated instantly

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Arbitrage Pricing Theory

• Summary of APT assumptions

– On the long run no arbitration opportunity
exists
– There is no costs or taxes on arbitrage
– Some investors are welling to perform large
diversified portfolios
– Systematic risk is the only relevant risk
(unsystematic risk can be totally be
diversified)

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APT Model

• APT applies to well diversified portfolios and

not necessarily to individual stocks.
• APT can be extended to multifactor models.

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APT and CAPM
APT
• Equilibrium means no
arbitrage opportunities.
• APT equilibrium is quickly
restored even if only a few
investors recognize an
arbitrage opportunity.
• The expected return–beta
relationship can be derived
without using the true market
portfolio.
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CAPM
• Model is based on an
inherently unobservable
“market” portfolio.
• Rests on mean-variance
efficiency. The actions of
many small investors restore
CAPM equilibrium.
• CAPM describes equilibrium
for all assets.
• It is difficult to estimate beta
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