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Portfolio Theory Part 4: CAPM & APT

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 Learning Objectives
The learning objectives for this section are to:

Understand the construct and use understand the describe the

derivation of the the Security Market derivation of APT similarities and
CAPM (assumptions Line (SML) and how to use the differences between
and characteristics model SIM, CAPM and APT
of equilibrium)

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 1. The CAPM

• The Capital Asset Pricing Model (CAPM) builds on Markowitz’s

portfolio theory and yields a model for determining the required rate
of return for any risky asset.
• It is a cornerstone of financial theory.
• It is based on numerous assumptions relating to individual investor
behaviour and the structure of the market. However, relaxing some
of these assumptions only has a minor impact on the assertions of
the model; it does not necessarily render the CAPM useless.
• Once we have knowledge of the assumptions, we can use these to
derive the model.

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 1.1 Assumptions

• The assumptions pertaining to investor behaviour include:

• Investors are rational mean-variance optimisers. This means that each

investor uses the Markowitz model to identify an optimal risky portfolio
and thereafter, their optimal capital allocation is based on their utility
function.
• Investors have a common single-period investment horizon. This
implies that investors are not concerned with anything that happens
after the single period (and thus it will not affect their current
investment decision). In practice, investors have different time horizons
which requires different risk measures.
• Investors have homogeneous expectations. This implies that all
investors will use the same inputs (expected returns and covariances) in
the Markowitz model. As such, all investors will generate identical
efficient frontiers and select the same optimal risky portfolio. As long
as differences in expectations are not significant, relaxing this
assumption will not have a major impact on the model.
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 • The assumptions pertaining to market structure include:

• Investments include only traded financial assets: this includes stocks,

bonds and bills. Other non-traded assets (e.g. human capital and
property) are excluded.
• Individual investors are price takers: this ensures that no single investor
can influence the market price of a security via their actions. This
assumption means that the wealth held by each investor is small relative
to the aggregate wealth of all investors.
• Investors can lend and borrow at the risk-free rate, and they can take
short positions on traded securities. It is always possible to lend at the
risk-free rate by buying assets such as T-bills; but it is not always possible
to borrow at this rate. However, even if we borrow at higher rates than
the risk-free rate the thrust of the model is not affected. There may be
restrictions on short-selling.

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 • Capital markets are in equilibrium: this implies that all investments are
properly priced in line with their risk levels.
• For every borrower in the market, there is a lender: this implies that,
on average, every investor invests in the market portfolio consisting of
all available traded assets.
• No taxes and transaction costs: investors will be in different tax
brackets, and this will affect the investments they wish to hold while
transaction costs may also make some trades less attractive. Relaxing
this assumption will modify the result of the CAPM but will not change
the thrust thereof.
• Information is costless and available to all investors: this assumption is
unrealistic as there is a high cost attached to macroeconomic and
security analysis.

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 1.2 Characteristics of the CAPM under Equilibrium
Because of the assumption of homogenous expectations
Characteristic 1:
• As all investors choose the same risky portfolio; the risky portfolio must
be the market portfolio (M) of all tradeable assets. The value of the
aggregate risky portfolio will equal the entire wealth of the economy,
with each asset held in proportion to its market value.
• If an asset is not in the market portfolio, there will be no demand for it
and its price will fall.
• But, as the asset becomes cheaper, it becomes more attractive (and
others become less attractive) and a point will be reached where it
becomes attractive enough to include in the optimal risky portfolio.
• This price adjustment ensures that all assets will be included in the
market portfolio.
• The CAL that is tangential to the efficient frontier is thus the capital
market line (CML) (as defined in PT 2) as the optimal portfolio is the
market portfolio of all risky assets.

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 Characteristic 2:
• If all investors hold the market portfolio, there is no need for complex
security analysis as the market portfolio, by virtue of its tangency with
the CML, is efficient. It is fully diversified.

Characteristic 3:
• Each investor chooses to invest a proportion y in M such that:

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𝑦𝑦 = [𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝐹𝐹 ]/ 𝐴𝐴𝜎𝜎𝑀𝑀

• Any borrowing position by an investor must be offset by a lending

position meaning that net borrowing and lending across all investors =
0. Thus the average position in the risky portfolio will be equal to 1 (y =
1). If the average investor’s risk aversion is Ā:
The equilibrium market risk premium
[𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝐹𝐹 ] = ̅ 𝑀𝑀
𝐴𝐴𝜎𝜎 2
is thus determined by the average risk
aversion of investors (𝐴𝐴̅) and the
market risk (variance).
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 From PT Part 2 slide 40:

Characteristic 4:
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• The variance of the market portfolio: 𝜎𝜎𝑀𝑀 = ∑𝑛𝑛𝑗𝑗=1 ∑𝑛𝑛𝑖𝑖=1 𝑤𝑤𝑖𝑖 𝑤𝑤𝑗𝑗 𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑖𝑖 , 𝑟𝑟𝑗𝑗
• The contribution of asset 1 to the variance of the market portfolio is:

𝑤𝑤1 [𝑤𝑤1 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅1 , 𝑅𝑅1 + 𝑤𝑤2 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅2 , 𝑅𝑅1 + 𝑤𝑤3 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅3 , 𝑅𝑅1 + ⋯ +
+ ⋯ + 𝑤𝑤𝑛𝑛 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑛𝑛 , 𝑅𝑅1 ]

• Every term in the square brackets can be rearranged as follows:

𝑤𝑤𝑖𝑖 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑖𝑖 , 𝑅𝑅1 = 𝐶𝐶𝐶𝐶𝐶𝐶 𝑤𝑤𝑖𝑖 𝑅𝑅𝑖𝑖 , 𝑅𝑅1

• Covariance is additive, so the sum of the terms in the square bracket is:

∑𝑛𝑛𝑖𝑖=1 𝐶𝐶𝐶𝐶𝐶𝐶 𝑤𝑤𝑖𝑖 𝑅𝑅𝑖𝑖 , 𝑅𝑅1 = 𝑐𝑐𝑐𝑐𝑐𝑐(∑𝑛𝑛𝑖𝑖=1 𝑤𝑤𝑖𝑖 𝑅𝑅𝑖𝑖 , 𝑅𝑅1 )

BUT ∑𝑛𝑛𝑖𝑖=1 𝑤𝑤𝑖𝑖 𝑅𝑅𝑖𝑖 = 𝑅𝑅𝑀𝑀

THEREFORE 𝑐𝑐𝑐𝑐𝑐𝑐(∑𝑛𝑛𝑖𝑖=1 𝑤𝑤𝑖𝑖 𝑅𝑅𝑖𝑖 , 𝑅𝑅1 ) = 𝑐𝑐𝑜𝑜𝑜𝑜 𝑅𝑅𝑀𝑀 , 𝑅𝑅1
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 • Therefore, the contribution of asset 1 to the variance of the market
portfolio is determined by its weighting in the portfolio and its
covariance with the market.

𝑤𝑤1 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑀𝑀 , 𝑅𝑅1

-ve covariance with the market means
that asset 1 makes a -ve contribution
to portfolio risk. Asset 1 thus provides
a risk premium that moves inversely
with the rest of the portfolio and
stabilises the return on the overall
portfolio.
+ve covariance with the market means
that asset 1 will make a +ve contribution
to portfolio risk because it reinforces
movements in the rest of the portfolio.
However, this does not mean that
diversification is not beneficial; excluding
the asset from the portfolio would require
its weight be assigned to the remaining
stocks and that reallocation would
increase variance even more.

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 • The contribution of asset 1 to the portfolio’s risk premium is given
as follows:

𝑤𝑤1 𝐸𝐸(𝑅𝑅1 ) 𝑤𝑤1 (𝐸𝐸(𝑟𝑟1 ) − 𝑟𝑟𝐹𝐹 )

• The reward-to-risk ratio for an asset is its contribution to the

portfolio risk premium divided by its contribution to the portfolio
variance:

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑤𝑤1 (𝐸𝐸(𝑟𝑟1 )−𝑟𝑟𝐹𝐹 ) (𝐸𝐸(𝑟𝑟1 )−𝑟𝑟𝐹𝐹 )
= =
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑡𝑡𝑡𝑡 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑤𝑤1 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑀𝑀 ,𝑅𝑅1 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑀𝑀 ,𝑅𝑅1

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 Characteristic 5:
• The reward-to-risk ratio for the market portfolio is:

𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 (𝐸𝐸(𝑟𝑟𝑀𝑀 )−𝑟𝑟𝐹𝐹 ) This ratio is known as the

= 2 market price of risk. It
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝜎𝜎𝑀𝑀
quantifies the extra return
that investors demand to
bear portfolio risk.

IMPORTANT
For components of the efficient market portfolio, we measure risk as the
contribution to portfolio variance (which depends on the covariance with
the market). In contrast, for the efficient market portfolio, variance is the
appropriate measure of risk.

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 Characteristic 6:
• The CAPM states that in equilibrium all securities should offer the
same reward-to-risk ratio. If they do not, investors would rearrange
their portfolios to favour the security with the better trade-off and shy
away from the other. This would result in price pressure until the
ratios are equalised. Thus, the reward-to-risk ratio for any security
must be equal to the reward-to-risk ratio of the market:

𝐸𝐸(𝑟𝑟1 )−𝑟𝑟𝐹𝐹 𝐸𝐸(𝑟𝑟𝑀𝑀 )−𝑟𝑟𝐹𝐹 𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑀𝑀 ,𝑅𝑅1

= 2
𝐸𝐸(𝑟𝑟1 ) − 𝑟𝑟𝐹𝐹 = 2 (𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝐹𝐹 )
𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑀𝑀 ,𝑅𝑅1 𝜎𝜎𝑀𝑀 𝜎𝜎𝑀𝑀

𝑪𝑪𝑪𝑪𝑪𝑪 𝑹𝑹𝑴𝑴 ,𝑹𝑹𝟏𝟏

𝑬𝑬(𝒓𝒓𝟏𝟏 ) = 𝒓𝒓𝑭𝑭 + 𝜷𝜷𝟏𝟏 (𝑬𝑬(𝒓𝒓𝑴𝑴 ) − 𝒓𝒓𝑭𝑭 ) where: 𝝈𝝈𝟐𝟐𝑴𝑴
= 𝜷𝜷𝟏𝟏

The risk-free rate (the Beta measures the contribution

A risk premium on a security within a
compensation for waiting i.e. of the security to the variance of
portfolio will be determined by the
the time value of money) the market portfolio as a fraction
market risk premium scaled by the
asset’s contribution to the risk of the of the total variance of the
overall portfolio (beta). market portfolio. 13
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 • The risk premium does not depend on the variance of the security.
• Rather, the CAPM shows that systematic (market) risk should be priced
but not firm-specific risk because the asset is held as part of a
diversified portfolio and so firm-specific risk should be diversified away
(i.e. the market does not reward investors for not diversifying).
• The expected return-beta relationship holds for each security and also
any combination of securities (i.e. a portfolio).
• The CAPM thus also holds for the market portfolio:

𝐸𝐸(𝑟𝑟𝑀𝑀 ) = 𝑟𝑟𝐹𝐹 + 𝛽𝛽𝑀𝑀 (𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝐹𝐹 )

The beta of the market is

thus 1. If β > 1, stocks have
𝐶𝐶𝐶𝐶𝐶𝐶 𝑅𝑅𝑀𝑀 ,𝑅𝑅𝑀𝑀 2
𝜎𝜎𝑀𝑀
greater systematic risk than
𝛽𝛽𝑀𝑀 = 2 = 2 =1 the market. If β < 1, stocks
𝜎𝜎𝑀𝑀 𝜎𝜎𝑀𝑀
have less systematic risk
than the market.
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 • Example 1: The market risk premium is 8%, with a standard deviation
of 22%. The covariance of Toyota and Ford’s share returns with the
market are 387.2 and 605 respectively.
(a) What are the betas of Toyota and Ford and what do they tell you
about the riskiness of the two shares?
(b) What is the risk premium on a portfolio invested 25% in Toyota
and 75% in Ford?

(a)

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 1.3 The Security Market Line (SML)
The expected return-beta
E (r)
relationship can be depicted
SML graphically as the security
market line (SML).

M Market risk premium

E (rM)

[E(rM) – rf] = Slope of the SML

rf
How does the SML differ from the
CML?
1 βM=1 β • The CML graphs the risk
premiums of efficient
Fairly priced securities plot on the SML i.e. their portfolios as a function of a
return is commensurate with risk. All securities must portfolio’s std dev.
lie on the SML in equilibrium. • The SML graphs individual
asset risk premiums as a
function of asset risk (beta).
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 • The SML can be used as a benchmark to obtain the fair expected return
on a risky asset. Security analysis is then undertaken to determine the
return an analyst forecasts for the asset. The forecasted return is then
compared to the return from the SML.

Alpha (α) = Forecast return – expected return from the SML

• If the forecast return > expected return from the SML, alpha is +ve
meaning the security is:
• Underpriced.
• Plots above the SML (i.e. given its beta, the forecast return is > than
predicted by the CAPM).
• It is a good buy.
• If the forecast return < expected return predicted by the SML, alpha is
–ve meaning the security is:
• Overpriced,
• It plots below the SML (i.e. given its beta, the forecast return is < than
predicted by the CAPM).
• It is a bad buy/ good sell. 17
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 From the graph: Stock A:
E(rM) = 14%, and rF = 10%, CAPM: E(r) = 10 + 1.5*4 = 16%.
Therefore: E(rM) – rF = 4% Analyst forecast is 18%.
Alpha = 18% - 16% = 2% (+ve).
E (r)
Thus stock A is a good buy.
A
18% SML
+α
16%
M
E (rM) = 14%

13%
rf = 10% -α
9%
B

βM = 1
0.75 1.5 β

Stock B:
CAPM: E(r) = 10 + 0.75*4 = 13%.
Analyst forecast is 9%,
Alpha = 13% - 9% = 4% (-ve).
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 • What happens to mispriced securities on the SML (like A and B)?
• In an efficient market, securities that plot above the SML (e.g. A) will be
in high demand resulting in an increase in the price which will result in a
fall in the expected return.
• Those below the SML (e.g. B) will be sold resulting in a fall in the price
which will result in a rise in the expected return.
• This will continue until the securities are fairly priced and plot on the
SML again and equilibrium is restored.
• But because investors are price takers, many investors must identify the
opportunity and trade on it in order to bring the market back to
equilibrium.

• Example 2: An analyst has forecast a return for Spar of 11%. The stock
has a beta of 1.1. The expected return on the market is 9% and the risk-
free rate is 0.5%. What is the alpha of Spar? Would you buy this share?

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 • The SML can also be used for performance evaluation to compare the
actual return to the expected return.
• If a stock overperformed, actual return > return predicted by the
SML = +ve alpha.
• If a stock is underperformed, the actual return < return predicted
by the SML = -ve alpha.
• The CAPM is also useful in capital budgeting to determine the required
rate of return on a project.

• Example 3: A share sells for R50 today. It will pay a dividend of R3 per share
at the end of the year. Its beta is 1.2. What do investors expect the stock to
sell for at the end of the year? The risk-free rate is 2% and E(rM) = 12%.

This is the holding

period return
formula. It is
important but not
provided on the
formula sheet as you
should know it.
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 1.4 Relaxing the Assumptions
No Transaction Costs

SML

E (r)
With transaction costs,
investors will not correct all
M
E (rM) mispricing as, in some
instances, the cost of buying/
selling the mispriced security
will not offset any potential
E (rf) excess return. Securities will
or thus plot close to, but not on,
E (rZ)
the SML. The SML will be a
band of securities

βM = 1
β

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 Lending and Borrowing occur at the Same Rate

Most borrowing occurs at a rate higher

E (r) than the lending rate. What are the
SML
implications of this for the SML?
M • Several portfolios exist where the
E (rM) returns are uncorrelated with the
market meaning that they are
E (rM) - E (rZ) similar in nature to the risk-free
asset. The beta for these portfolios
E(rZ) is zero. We select the zero-beta
portfolio which has the lowest
variance.
• As such, this does not affect the
βM=1 construction of the SML, with the
β return on the minimum-variance
zero-beta portfolio replacing the
risk-free rate.

𝐸𝐸(𝑟𝑟𝑖𝑖 ) = 𝐸𝐸(𝑟𝑟𝑧𝑧 ) + 𝛽𝛽𝑖𝑖 (𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝐸𝐸(𝑟𝑟𝑧𝑧 ))

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 1.5 CAPM vs SIM
• SIM states that the realised excess return on a stock is the sum of the
realised excess return due to market factors, a non-market risk premium
and firm specific shocks. Because the expected value of firm-specific
surprises is zero, the expected excess return of a stock is given by:

𝑅𝑅𝑖𝑖 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖𝑅𝑅𝑀𝑀 + 𝑒𝑒𝑖𝑖 𝐸𝐸(𝑅𝑅𝑖𝑖 ) = 𝛽𝛽𝑖𝑖𝐸𝐸(𝑅𝑅M) + 𝛼𝛼𝑖𝑖

• The CAPM equation:

𝐸𝐸(𝑟𝑟𝑖𝑖 ) = 𝑟𝑟𝐹𝐹 + 𝛽𝛽𝑖𝑖 (𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝐹𝐹 ) 𝐸𝐸(𝑟𝑟𝑖𝑖 ) − 𝑟𝑟𝐹𝐹 = 𝛽𝛽𝑖𝑖 (𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝐹𝐹 )

• Therefore … the major difference is alpha (𝜶𝜶𝒊𝒊):

• CAPM: a security should only provide a premium over the risk-free rate if the
security imposes systematic risk for which the investor must be
compensated. A +ve alpha implies reward without risk and market pressure
will eventually force the alphas to zero (in an efficient market).
• SIM: alpha is a source of the risk premium but these will average out to zero
across all securities.

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 1.6 Estimating the CAPM

• Use historical data (usually monthly data for five years).

• Regress excess returns of a security against excess returns of the market.
𝑟𝑟𝑖𝑖𝑖𝑖 − 𝑟𝑟𝑓𝑓 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 (𝑟𝑟𝑀𝑀𝑀𝑀 − 𝑟𝑟𝑓𝑓 ) + 𝜀𝜀𝑡𝑡 𝑅𝑅𝑖𝑖𝑖𝑖 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑅𝑅𝑀𝑀𝑀𝑀 +𝜀𝜀𝑡𝑡

• From the regression output:

• Slope coefficient = beta. We can then use this in applications of the
model going forward.
• BUT, there are other parts of the output which give us valuable info:
• Intercept = alpha. If CAPM holds, returns should be fully explained by
systematic risk and therefore should be zero. If the intercept differs
from zero, this shows that the CAPM does not hold.
• Adjusted R2 = how much of the variation in the stock’s excess returns
are explained by the market excess returns. Higher R2, the greater
the explanatory power of the CAPM. Useful metric for comparing
models.

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 Example 4: The CAPM has been estimated for RCL using monthly data for
a five-year period. The output is shown below.
(a) What is the beta of RCL? And comment on the magnitude thereof.
(b) If the expected return on the market for 2023 is 6% and the risk-free
rate is 0.5%, what is the expected return on RCL for 2023?
(c) How good a fit is the CAPM?

Coefficients Standard Error t Stat P-value

Intercept -0.0304 0.0149 -2.0406 0.0458
X Variable 1 0.4100 0.2133 1.9219 0.0595
Adjusted R Square 0.1434

(a) β = 0.41. It is significant at 10% (p-value of 0.0595 < 0.1). The value of
0.41 suggests that the firm is defensive (which makes sense given that it
produces consumer staples).
(b) E(ri ) = rF + βi (E(rM ) − rF ) = 0.5 + 0.41*(6 – 0.5) = 2.76%
(c) Alpha = -0.03 (significant at 5% as p-value of 0.0458 < 0.1); therefore the
CAPM does not hold. The model can only explain 14.34% of the excess
returns on RCL’s shares.

25
FTX3044F
 2. Arbitrage Pricing Theory (APT)
2.1 Multifactor Models
• Recall from PT Part 3 that based on the single-factor model uncertainty in
asset returns arises from two sources:
• a systematic common factor that captures unexpected changes in the
economy, and
• firm-specific factors.
• Common factors could include GDP growth, interest rates, inflation etc. In
deriving SIM, we proxied the common factor by the market portfolio,
arguing that the market return reflects all macroeconomic factors as well
as the average sensitivity of firms to those factors.
• But is the single factor a good representation of systematic risk?

Multifactor models can provide a better description of individual security

returns as they allow (i) a more explicit representation of systematic risk,
(ii) securities to exhibit different sensitivities to various macroeconomic
risks and (iii) more effective management of these components of risk

26
FTX3044F
 Firm-specific
influences with
𝑅𝑅𝑖𝑖 = 𝐸𝐸(𝑅𝑅𝑖𝑖 ) + 𝛽𝛽𝑖𝑖𝐹𝐹1 𝐹𝐹1 + 𝛽𝛽𝑖𝑖𝐹𝐹2 𝐹𝐹2 + ⋯ 𝛽𝛽𝑖𝑖𝐹𝐹𝑛𝑛 𝐹𝐹𝑛𝑛 + 𝑒𝑒𝑖𝑖 zero expected
value.

There is no theory in
the multifactor model
that explains 𝐸𝐸(𝑅𝑅𝑖𝑖 ). The factors (𝐹𝐹1 , 𝐹𝐹2 ) represent The coefficients of each factor (𝛽𝛽1 ,
changes in the macroeconomic 𝛽𝛽2 ) measure the sensitivity of the
variables that have not been security returns to that factor. Also
anticipated (i.e. macroeconomic called factor loadings/ factor betas.
surprises) and therefore have
zero expectation.

The value of the factor (𝐹𝐹1 ) is the unexpected change in the macroeconomic variable
calculated as: actual – expected.

• Example 5: A security has an expected risk premium of 9% and a beta

to GDP growth of 1.5. Analysts expected GDP growth of 5% but actual
GDP growth was 3%. What would the impact be on the risk premium?
𝑅𝑅𝑖𝑖 = 𝐸𝐸(𝑅𝑅𝑖𝑖 ) + 𝛽𝛽𝑖𝑖𝐹𝐹1 𝐹𝐹1 (assume there is only a single factor)
Ri = 9 + 1.5*(3 - 5) = 6%
The actual risk premium was 3% lower than expected (9% - 6%).
27
FTX3044F
 • Consider a single-factor model. The excess return on an n-stock portfolio
with weights 𝑤𝑤𝑖𝑖 :

𝑅𝑅𝑝𝑝 = 𝐸𝐸(𝑅𝑅𝑝𝑝 ) + 𝛽𝛽𝑝𝑝 𝐹𝐹 + 𝑒𝑒𝑝𝑝

• As shown in PT Part 3, 𝜎𝜎2 𝑒𝑒𝑝𝑝 approaches zero as the number of

securities in the portfolio increases. A well-diversified portfolio is thus
one where each weight, 𝑤𝑤𝑖𝑖 , is small enough that for practical purposes
the unsystematic (residual) variance, 𝜎𝜎 2 (𝑒𝑒𝑝𝑝 ), is negligible. Consequently,
we can write:
𝑅𝑅𝑝𝑝 = 𝐸𝐸(𝑅𝑅𝑝𝑝 ) + 𝛽𝛽𝑝𝑝 𝐹𝐹

• Thus, the return of a well-diversified portfolio is completely determined

by the systematic risk factor. This is illustrated on the next slide (and
compared to a single-stock).

28
FTX3044F

Well-Diversified Portfolio (P)
Excess Return (%)
10
0 F
Realisation of
the macro factor
FTX3044F
• The graph shows excess returns as
a function of the realisation of the
systematic factor for a well-
diversified portfolio, with βP = 1.
• E(RP) = 10% which is where the
solid line crosses the vertical axis.
At this point, the systematic factor
is zero meaning there are NO
surprise returns from the macro
factor.
• From the model, if the macro-factor
is +ve, the portfolio’s return >
expected return; if the macro-factor
is –ve, the portfolio’s return <
expected return. The excess return
on the portfolio:
𝑅𝑅𝑝𝑝 = 𝐸𝐸(𝑅𝑅𝑝𝑝 ) + 𝛽𝛽𝑝𝑝 𝐹𝐹 =10% + 1𝐹𝐹
29
 Single Stock (S)
• In contrast, this graph shows
excess returns as a function of
the systematic factor for a single Excess Return (%)
stock, with E(RS) = 10% and βS =
1.
• The undiversified stock is subject
to unsystematic risk, which is
seen in a scatter of points 10
around the solid line compared
to the well-diversified portfolio,
whose return is completely F
determined by the systematic 0
risk factor.

Our focus going forward is thus on well-diversified portfolios whose

returns are completely determined by the systematic risk factor.
30
FTX3044F
 2.2 The theory of APT

• An arbitrage opportunity arises when an investor can earn riskless

(certain) profits without making a net investment.
• The Law of One Price (LOOP) states that the price of an identical asset
should be the same across markets. If arbitrageurs observe a violation
of LOOP, they will engage in arbitrage activity – simultaneously buying
the asset where it is cheap and selling it where it is expensive. Price
pressures will result in the elimination of the arbitrage opportunity.
• All arbitrage opportunities thus involve long-short positions such
that the net investment is zero.
• The position is riskless and thus any investor, regardless of risk
aversion or wealth, will want to take up an infinite position in it.
• In an efficient market, profitable opportunities will disappear
quickly.

31
FTX3044F
 Well-diversified portfolios with equal betas must have the same expected return,
failing which, an arbitrage opportunity exists.

Buy low/sell If you short sell R1mil of B and buy R1mil

Given: high principle* of A, you will have a riskless payoff as
E(RA) = 10% and βA = 1. follows:
E(RB) = 8% and βB = 1 Long A: (0.10 + 1*F) * R1mil
Short B: -(0.08 + 1*F) * R1mil
A
Excess Return (%) +0.02 * R1mil = R20 000
B

• The profit is risk-free because factor

risk cancels out over the long and short
10 positions.
8 • The net investment = zero.
• Arbitrageurs pursuing this opportunity
F will result in price pressure forcing the
0
return discrepancy between the two
portfolios to disappear.

32
FTX3044F
 What about well-diversified portfolios with different betas? Their risk premiums
must be proportional to their betas, failing which, an arbitrage opportunity exists.
Given E(RA) = 10% and βA = 1; How do we know if Portfolio C is fairly
Rf = 4% priced?
E(RC) = 6% and βC = 0.5. Construct a new portfolio (N) with the same
beta as C using the other portfolios. To do
Excess return (%) this, we solve for the following:
βN = 0.5 = wN*0 + (1 - wN)*1
wN = 0.5
A Calculate the E(R) of the new portfolio:
10 E(RN) = (0.5*4) + (0.5*10) = 7%
βN = βC but E(RN) > E(RC) meaning that an
N Risk
7 arbitrage opportunity exists.
Premium
6 C
rf= 4
F Long N: (0.07 + 0.5*F) * R1mil
Short C: -(0.06 + 0.5*F) * R1mil
+0.01 * R1mil = R10 000
0.5 1 βF Therefore to rule out arbitrage
opportunities, well-diversified portfolios
33
FTX3044F must lie on the line F-A.
 • We would like a SML that relates the portfolio risk premium to its beta
against a market index rather than an unspecified macro factor.
• If a market index portfolio is well-diversified, its return will perfectly
reflect the value of the macro factor. Thus, betas measured against the
market index will capture the same information about relative levels of
systematic risk as the betas measured against the macro factor. This
gives us the following:
𝑅𝑅𝑝𝑝 = 𝛼𝛼𝑝𝑝 + 𝛽𝛽𝑝𝑝 𝑅𝑅𝑀𝑀
• The expected excess return can be expressed as:
This is identical
This is the APT
equation:
𝐸𝐸(𝑅𝑅𝑝𝑝 ) = 𝛽𝛽𝑝𝑝 𝐸𝐸(𝑅𝑅𝑀𝑀 ) to the SML of
the CAPM.

• Thus, the SML of the CAPM must also apply to well-diversified

portfolios due to the ‘no arbitrage’ requirement of the APT.

34
FTX3044F
 2.3 APT vs CAPM

• APT, like the CAPM, predicts an SML linking expected returns to beta.
But the restrictive assumptions do not apply. APT relies on three key
principles:
(1) Security returns can be described by a factor model.
(2) There are sufficient securities to diversify away firm-specific risk.
(3) Well-functioning security markets do not allow for the
persistence of arbitrage opportunities.
• APT thus proves that the main conclusion of the CAPM (the expected
return-beta relationship) is approximately valid.
• APT, like the CAPM, gives us a benchmark for rates of return that can
be used in (i) capital budgeting, (ii) security valuation or (iii) investment
performance evaluation.
• The model also distinguishes between non-diversifiable risk, which
requires a reward, and diversifiable risk, which does not.

35
FTX3044F
 • Advantages of APT compared to the CAPM:
• Relies on the highly plausible assumption of no arbitrage opportunities.
• Does not require all investors to be mean-variance optimisers.
• A violation of the pricing relationship will be restored quickly even if only a few
investors are aware of the mispricing whereas with CAPM many investors have
to implement the arbitrage strategy to restore equilibrium because it assumes
no one investor can influence the price (an assumption APT does not require).
• Provides the expected return-beta relationship using a well-diversified portfolio
that can be constructed from a large number of securities and does not rely on
the unobservable market portfolio that includes all assets, as with the CAPM. A
well-diversified index portfolio can suffice for the APT. Thus, the APT is more
flexible than the CAPM.

• Disadvantages of the APT compared to the CAPM:

• CAPM describes equilibrium for all assets. APT applies to well-diversified
portfolios and does not necessarily hold for all individual securities (i.e. it is
possible for some individual securities to be mispriced meaning that they do not
lie on the SML).
• APT rests on the foundation of well-diversified portfolios but even large
portfolios may have non-negligible residual risk.
36
FTX3044F
 2.4 APT with Many Factors

• The single-factor APT (from slide 33) can be extended to a multifactor

model as follows:

𝐸𝐸(𝑟𝑟𝑝𝑝 ) = 𝑟𝑟𝐹𝐹 + 𝛽𝛽𝑝𝑝𝐹𝐹1 (𝐸𝐸 𝑟𝑟1 − 𝑟𝑟𝐹𝐹 ) + 𝛽𝛽𝑝𝑝𝐹𝐹2 (𝐸𝐸 𝑟𝑟2 − 𝑟𝑟𝐹𝐹 )
• where: 𝐸𝐸 𝑟𝑟1 and 𝐸𝐸 𝑟𝑟2 are the expected returns on factors 1 and 2
respectively.

The factors are well-diversified portfolios
that are constructed to have a beta of 1
on one of the factors and a beta of zero
on any other factor. The returns on the
portfolio thus track the evolution of one
particular source of macroeconomic risk
but are uncorrelated with other sources
of risk.
FTX3044F
This multifactor model gives rise to a
multidimensional SML that predicts
that the contribution of each source
of risk to the security’s total risk
premium equals the factor beta times
the risk premium of the factor
portfolio tracking that source of risk.
37
 • Example 6: Portfolio A has a beta on the GDP factor of 0.5 and a beta on
the interest rate factor of 0.2. The GDP and interest rate factors have
expected returns of 10% and 12% respectively and the risk-free rate is
1%.
a) Calculate the expected return on portfolio A using APT.
b) Suppose that the market’s expected values for GDP and the
interest rate were 3% and 2% respectively but the actual values
turned out as 5% and 0% respectively. Calculate the revised total
return on portfolio A.

Factor value = actual

value – expected value.

Thus, the APT gives us a means of computing the expected return of an asset based on its
sensitivity to macro factors. We can then determine changes to this return when there are
FTX3044F surprises to the macro factors. 38