First Semester, 2023-2024

THE UNIVERSITY OF HONG KONG

DEPARTMENT OF STATISTICS AND ACTUARIAL SCIENCE

STAT3904 CORPORATE FINANCE FOR ACTUARIAL SCIENCE

Tutorial 7: Arbitrage Pricing Theory (APT)

1 Key Learning Points

In the examination, candidates are expected to:

LP(1) State, prove and interpret the one-factor APT.

LP(2) State, prove and interpret the multi-factor APT.

2 Review of Key Concepts

2.1 Introduction to APT

• The Arbitrage Pricing Theory (APT) is an approach to determine asset values based on
the no-arbitrage principle.

• It is a multi-factor model describing how the security returns move with certain sources
of movements, called economic factors. The coefficients of the factors are called factor
sensitivities or factor loadings.

• Unlike CAPM, APT is not an equilibrium asset pricing model. In other words, it is not
necessary to assume that everyone is optimizing as in CAPM. In fact, we need very few
assumptions to establish the APT.
Assumptions for APT:

– All securities have finite expected values and variances.

– Some agents can form well-diversified portfolios.

– There are no taxes.

– There are no transaction costs.

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2.2 One-factor APT

Consider a one-factor model with n assets, modelled by

Ri = ai + bi ξ,

where ξ is a stochastic factor and ai and bi are scalars for all i. Its vector form is naturally
R = a + bξ. Without loss of generality, we assume that the initial price of every asset is 1.

Now fix a portfolio X with zero initial wealth, i.e., X T 1 = 0, together with the condition
X T b = 0, so that the sensitivity of the portfolio to the stochastic factor is 0. Then the
corresponding portfolio return can be expressed as

X T R = X T (a + bξ) = X T a,

which is deterministic. According to the no-arbitrage assumption, the return of any determin-
istic portfolio with zero initial wealth must be zero, hence X T a = 0. By the standard result in
linear algebra, the vector a can be written as a linear combination of 1 and b, or

a = λe0 1 + λe1 b

for some scalars λe0 and λe1 , which further implies

E(Ri ) = ri = ai + bi E(ξ) = λ0 + λ1 bi ,

where λ0 = λe0 and λ1 = λe1 + E(ξ). If the risk-free asset is present in addition, then λ0 should
be equal to rf .

2.3 Multi-factor APT

By a similar argument together with the use of well-diversified portfolios, we have the following
generalized version of APT:
Theorem 1. Suppose that there are n assets in the market and k economic factors, and the
random return for a security i is modelled by
k
X
Ri = ai + bij ξj + ei , (1)
j=1

where ei is the idiosyncratic (unique) risk for the i-th security which has zero mean and is
uncorrelated with other factors, then there exists k + 1 coefficients λj , j = 0, 1, ..., k, such that
k
X
E(Ri ) = ri = λ0 + bij λj . (2)
j=1

Remark 1. This equation specifies the linear relation between the expected return of a security
and its factor sensitivities.

• The price of risk λi indicates the extra return for each extra unit of risk in the portfolio.
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• If there is a risk-free asset, then the portfolios with no risk (i.e., bij = 0 for all i, j) must
have a return at the risk-free rate, i.e., λ0 = rf .

An alternative form of the Arbitrage Pricing Line (2) is

Xk
ri − rf = bij (E(ξl ) − rf ),
l=1

where E(ξl ) = λl + rf , l = 1, 2, ..., k is the expected return on a portfolio with unit sensitivity
to the l-th factor and zero sensitivity to all the other factors.
Cov(R ,ξ )
Remark 2. If ξj ’s are uncorrelated, then bij = Var(ξij )j . Besides, under the simple APT, there
is no noise term and the arbitrage portfolio can be constructed by choosing a portfolio with
zero sensitivity to all factors; see Question 1 for example.

Exercise 1. Consider the following simplified APT model:

Factor Expected risk premium
Market 6.4%
Interest rate −0.6%
Yield spread 5.1%

Calculate the expected return for the following stocks. Assume rf = 5%.

Stock b1 (Market) b2 (Interest rate) b3 (Yield spread)

A 1 −2 −0.2
B 1.2 0 0.3
C 0.3 0.5 1

Solution. By directly applying (2), we can calculate the expected return for Stock A as

rA = 0.05 + 1 × 0.064 + (−2) × (−0.006) + (−0.2) × 0.051 = 0.1158.

Analogously,

rB = 0.05 + 1.2 × 0.064 + 0 × (−0.006) + 0.3 × 0.051 = 0.1421,

rC = 0.05 + 0.3 × 0.064 + 0.5 × (−0.006) + 1 × 0.051 = 0.1172.

3 Problems

Attempt ALL THREE questions. Marks for past paper questions are shown in square brack-
ets.

1. Two stocks are assumed to satisfy the two-factor model:

(
R1 = a1 + 2ξ1 + ξ2 ,
R2 = a2 + 3ξ1 + 4ξ2 .
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In addition, there is a risk-free asset with a rate of return of 10%. It is known that E(R1 ) =
15% and E(R2 ) = 20%. What are the values of λ0 , λ1 and λ2 for this model?

Solution. Since the risk-free asset is present in the market, we immediately conclude that
λ0 = rf = 0.1. To find λ1 and λ2 , it suffices to solve the following system of equations:
(
E(R1 ) = 0.15 = 0.1 + 2λ1 + λ2 ,
E(R2 ) = 0.2 = 0.1 + 3λ1 + 4λ2 ,

which yields λ1 = 0.02 and λ2 = 0.01. Therefore, the Arbitrage Pricing Line is given by

r = 0.1 + 0.02b1 + 0.01b2 ,

where b1 and b2 are determined by the specific portfolio X = (x1 , x2 ).

2. Imagine that there are only two pervasive macroeconomic factors. Investments X, Y and Z
have the following sensitivities to these two factors:

Investment b1 b2
X 1.75 0.25
Y −1 2
Z 2 1

We assume that the expected risk premium is 4% on Factor 1 and 8% on Factor 2. Treasury
bills offer a zero risk premium by default.

(a) Suppose that an investor buys $200 of X and $50 of Y , and sells $150 of Z. What is
the sensitivity of the portfolio to each of the two factors?
(b) Suppose that an investor buys $80 of X and $60 of Y , and sells $40 of Z. Under APT,
what is the expected risk premium of the portfolio?
(c) Suppose that APT does not hold and that X offers a risk premium of 8%, Y offers a
premium of 14%, and Z offers a risk premium of 16%. Devise an investment that has
zero sensitivity to each factor and that has a positive risk premium.

Solutions. (a) Take $100 as a unit, then the portfolio is (πX , πY , πZ ) = (2, 0.5, −1.5). The
portfolio sensitivity to Factor 1 is the weighted sum of the sensitivities of the three
stocks to Factor 1:
2 × 1.75 + 0.5 × (−1) − 1.5 × 2 = 0.
Similarly, the portfolio sensitivity to Factor 2 is 2 × 0.25 + 0.5 × 2 − 1.5 × 1 = 0.
(b) The portfolio is (πX , πY , πZ ) = (0.8, 0.6, −0.4). Following the same approach as in part
(a), the portfolio sensitivity to Factor 1 is 0.8 × 1.75 + 0.6 × (−1) − 0.4 × 2 = 0, while
that to Factor 2 is 0.8 × 0.25 + 0.6 × 2 − 0.4 × 1 = 1. Therefore, the expected risk
premium of the portfolio is 0.04 × 0 + 0.08 × 1 = 0.08.
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(c) By solving the following system of equations:

(
1.75πX − πY + 2πZ = 0,
0.25πX + 2πY + πZ = 0,

we can see that the portfolio (πX , πY , πZ ) = (2, 0.5, −1.5) has zero sensitivity to both
factors, which can also be concluded from part (a). The corresponding risk premium
is then
2 × 0.08 + 0.5 × 0.14 − 1.5 × 0.16 = −0.01,
and therefore, short-selling the portfolio can yield a positive risk premium.

3. The following information is provided for a stock market in which asset returns respond to
two factors:

Asset bj1 bj2 µj

A 1.2 0.4 16%
B 0.8 1.6 26%
rf 0 0 6%

In the table above, bj1 and bj2 , j = A, B, denote the respective sensitivities of the rates of
return on assets A and B to the factors, µj is the expected rate of return on each of the
assets, and rf is the risk-free rate of return.

(a) If APT holds in this market, calculate the risk premia corresponding to the two factors.
(b) Construct a portfolio which gives unit weight to the first factor and zero weight to the
second factor. Hence or otherwise, provide an interpretation for the risk premia under
APT.
(c) Asset C is also traded in this market and yields an average return of 12%, with bC1 = 1
and bC2 = 0.5. What can you conclude about the asset market from the additional
information?

Solutions. (a) Under APT, the risk premia for assets A and B lead to the folllowing system
of equations: (
0.16 − 0.06 = 1.2λ1 + 0.4λ2 ,
0.26 − 0.06 = 0.8λ1 + 1.6λ2 ,
which yields λ1 = 0.05 and λ2 = 0.1.
(b) Let the weights of A and B in the portfolio P be aA and aB respectively, and the
weight of the risk-free asset be a0 . By the assumption that the sensitivities bP 1 = 1
and bP 2 = 0, we have the following system of equations:
(
1 = 1.2aA + 0.8aB ,
0 = 0.4aA + 1.6aB ,

which yields aA = 1 and aB = −0.25. It is then easy to see that a0 = 1−aA −aB = 0.25,
µP = a0 rf + aA µA + aB µB = 0.11, and the excess expected return is µP − rf = 0.05,
which is exactly equal to λ1 .
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This relationship always holds since the portfolio is constructed such that it assigns
unit weight to Factor 1 and zero weight fo Factor 2. In fact, the coefficients λj ’s are the
risk premia corresponding to factors, because λj equals the risk premium on a portfolio
(or asset) whose return is solely affected by the corresponding factor j.
(c) The expected rate of return for asset C predicted by the APT should be λ1 bC1 +λ2 bC2 +
rf = 0.16, which exceeds the observed yield 0.12. This implies in the context of APT
that asset C is overpriced. Several plausible explanations are as follows:
• There are profitable investment opportunities as a consequence of asset market
disequilibrium (sell asset C and buy a combination of asset A and asset B, which
lies on the arbitrage pricing line).
• The specified APT is not an appropriate model for these markets.

********** END OF TUTORIAL 7 **********