CHAPTER TEN

ARBITRAGE PRICING THEORY AND MULTIFACTOR

MODELS OF RISK AND RETURN

CHAPTER OVERVIEW
This chapter extends the analysis of the index model of the prior chapter to develop multifactor models
and the arbitrage-pricing framework. The chapter begins with development of single and multifactor
models. The arbitrage-pricing framework rules out the possibility of arbitrage profits, that is, the
exploitation of mispriced securities. Arbitrage pricing theory uses a no-arbitrage argument to derive the
same expected return/risk relationship.

LEARNING OBJECTIVES
After studying Chapter ten, the student should also have a thorough understanding of factor models and
the arbitrage pricing theory (APT) and to be able to use APT to identify mispriced securities. The student
should also understand the similarities and differences between the two models and the limitations of
each.

PRESENTATION OF MATERIAL
10.1 Multifactor Models: An Preview
This section opens with the derivation of the single factor model. The single factor model (Equation
10.1) uses a single macro-economic factor to predict returns. The extension to multifactor models (e.g.,
Equation 10.2) is the developed. The examples developed are fairly standard, but the analysis can be
extended to other macro-economic factors. Factor loadings or factor betas are considered an Example
10.2 illustrates a risk assessment using multifactor models. Figure 10.1 shows the return on stock
(colored) and mutual fund (black) over five-year period.

10.2 Arbitrage Pricing Theory

The concept of arbitrage and how it relates to single and multi factor models is the topic of discussion for
this section. Arbitrage opportunities exist if an investor can construct a zero investment portfolio with a
sure profit and they violate the Law of One Price. If such opportunities exist, an investor can take large
positions to secure riskless profits. In efficient markets if profitable arbitrage opportunities exist, traders
will take positions to secure the riskless profit such opportunities to disappear quite quickly.

A similar result is found to the single index model regarding diversification. For well-diversified
portfolios we find that the error term approaches zero as the number of securities gets large. Figure 10.2
presents a side-by-side comparison of the excess returns as a function of systematic factor for well-
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of McGraw-Hill Education.
diversified portfolio and a single stock. If a security was mispriced, arbitrage conditions would be
possible. Any investor could short the overpriced security and use the funds to duplicate the risk level by
investing half of the funds in the market portfolio and half in the risk-free security. This would generate
arbitrage profits. As the riskless profit was taken, prices would adjust and the market would move back
to equilibrium. The Security Market Line relationship results when the market index portfolio is used as
the factor. Figure 10.3 illustrates the returns as a function of the systematic factor and Figure 10.4
illustrates an arbitrage opportunity. Finally, the no-arbitrage equation is derived, informing the
relationship between the APT and the CAPM

10.3 The APT, the CAPM, and the Index Model

The APT provides an expected return–beta relationship using as a benchmark a well-diversified index
portfolio rather than the elusive and impossible-to-observe market portfolio of all assets that underpins
the CAPM. When we replace the unobserved market portfolio of the CAPM with a broad, but
observable, index portfolio, we can no longer be sure that this portfolio will be an adequate benchmark
for the CAPM’s security market line.

10.4 A Multifactor APT

There are several sources of systematic risk such as uncertainty in the business cycle, interest
rates, energy prices, and so on. Presumably, exposure to any of these factors will affect a stock’s
appropriate expected return. The APT can be generalized to accommodate these multiple
sources of risk in a manner much like the multifactor CAPM. Examples 10.3 and 10.4 provide an
illustration of multifactor SML and mispricing and arbitrage respectively.

10.5 The Fama-French (FF) Three-Factor Model

The FF model provides a refined and tested example of the theories explained before. Emphasis is placed
on the SMB (Small Minus Big = the return of a portfolio of small stocks in excess of the return on a
portfolio of large stocks) and HML (High Minus Low = the return of a portfolio of stocks with a high
book-to-market ratio in excess of the return on a portfolio of stocks with a low book-to-market ratio) as
well as market return as the defining factors in determining excess rates of return.

Equation 10.10 provides a generalize regression of Equation 10.1 of the single-factor model. The three
betas measure Amazon’s sensitivities to the hypothesized systematic risk from market index (M), value-
versus-growth factor (HML), and size factor (SMB).

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.