Index Models &

Multi-factor
Models
Week 8
Investments FNCE30001

Dr Patrick J Kelly
Finance
 Warning

This material has been reproduced and communicated to you by

or on behalf of the University of Melbourne pursuant to Part VB
of the Copyright Act 1968 (the Act).

The material in this communication may be subject to copyright

under the Act.

Any further copying or communication of this material by you

may be the subject of copyright protection under the Act.

Do not remove this notice

 Last week
Last week, we learned that under some strict assumptions that the expected
return of any asset or portfolio, 𝑖𝑖, is the following:

𝐸𝐸 𝑟𝑟�𝑖𝑖 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖 𝐸𝐸 𝑟𝑟�𝑀𝑀 − 𝑟𝑟𝑓𝑓

Today we learn how to estimate the CAPM 𝛽𝛽 for any asset and we learn about
one theory, Arbitrage Pricing Theory (APT) that allows more than just the
market as a source of risk.

3
 Lingering Questions from
Markowitz and the CAPM

1. CAPM: How do we estimate beta?

2. Markowitz Model: How do we estimate
variances and covariances for risky
assets?
3. CAPM: What if there are more sources of
risk than just co-movement with the
market?
4
 Lecture Overview
Index Models
• How to estimate CAPM 𝛽𝛽
• Using 𝛽𝛽 to estimate variances and covariances

Multifactor Models
• Fama-French 3-Factor Models (A Data-Driven Model)
Arbitrage Pricing Theory

5
 Reading
Chapter 8: Index Models (excluding 8.5 “Portfolio Construction using the Single-
Index Model”)
Chapter 10: Arbitrage Pricing Theory and Multifactor Models of Risk

6
How do we estimate
the CAPM 𝛽𝛽 ?

7
Index Models

8
 Index Models
An index model is a statistical way to represent an asset pricing model as a
function systematic and idiosyncratic return:

Systematic

𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓 + 𝜀𝜀𝑖𝑖,𝑡𝑡

Idiosyncratic

𝛽𝛽𝑖𝑖 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓 is the return due to exposure (𝛽𝛽) to the market.
𝜀𝜀𝑖𝑖,𝑡𝑡 is a mean-zero surprise return that is unique to asset i.
𝛼𝛼𝑖𝑖 is the average return of the stock not explained by exposure to the market.
More on 𝛼𝛼𝑖𝑖 later
9
 Decomposing Risk
This form:
𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖,𝑀𝑀 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 + 𝑒𝑒𝑖𝑖,𝑡𝑡

Translates directly into risks and with 𝛼𝛼𝑖𝑖 constant, and assuming 𝑟𝑟𝑓𝑓 constant,
then:
2
𝜎𝜎𝑟𝑟2𝑖𝑖 = 𝛽𝛽𝑖𝑖,𝑀𝑀 𝜎𝜎𝑟𝑟2𝑀𝑀 + 𝜎𝜎𝑒𝑒2𝑖𝑖

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 + 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓_𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

10
Estimating
Index Models
with OLS

11
 OLS Estimation of an Index Model
It can be shown that the single-Index Model 𝛽𝛽 and the CAPM 𝛽𝛽 are identical:

𝑐𝑐𝑐𝑐𝑐𝑐 𝑟𝑟𝑖𝑖̃ , 𝑟𝑟𝑀𝑀

̃
𝛽𝛽𝑖𝑖 = 2
𝜎𝜎𝑀𝑀

Our goal: Estimate 𝛼𝛼𝑖𝑖 and 𝛽𝛽𝑖𝑖 in the Single-Index Model

𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑡𝑡

This is exactly what an Ordinary Least Squares (OLS) regression does

12
 Security Characteristic Line (SCL)
𝐸𝐸 𝑟𝑟𝑖𝑖̃ − 𝑟𝑟𝑓𝑓̃ |𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 = 𝛼𝛼�𝑖𝑖 + 𝛽𝛽̂𝑖𝑖 𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓
60%
Stock Excess Return (𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 )

50%

40% 𝜀𝜀𝑖𝑖,𝑡𝑡
30%

𝛽𝛽̂𝑖𝑖 =Slope
20%

10%

0%
𝛼𝛼�𝑖𝑖 =Intercept

-10%

-20%
-15% -10% -5% 0% 5% 10% 15% 20% 25% 30% 35%
13
Market Excess Return (𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 )
 Example: How to estimate the SCL
𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑡𝑡
Need:
• Risk free rate
• Stock return
• Market return (MSCI World; ASX 200 or Australia All Ordinaries; other market
index)

Details, details:
• Pay attention to the risk-free rate, because that is usually stated yearly
• What frequency are returns? Common is Monthly
• How long?
– Common is to use 60 months.
– Some use a year of daily or weekly data
14
 Woolworth’s Beta using Excel
Risk-free = 1 month “Bank Accepted
Market Return = ASX200
Bills/Negotiable Certificates of Deposit” ÷ 12

15
Woolworth’s Beta using Excel

16
 Woolworth’s Beta using Excel

𝜎𝜎𝑒𝑒𝑖𝑖

Variation in Woolies’ returns explained by the ASX200

2 2
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝛽𝛽𝑖𝑖,𝑀𝑀 𝜎𝜎𝑟𝑟
𝛼𝛼 𝛽𝛽 𝑅𝑅2 = 𝜌𝜌2 = = 2 2 𝑀𝑀 2 17
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝛽𝛽𝑖𝑖,𝑀𝑀 𝜎𝜎𝑟𝑟𝑀𝑀 + 𝜎𝜎𝑒𝑒𝑖𝑖
 Woolworth’s SCL
Woolies Excess Return (𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 )

Market Excess Return (𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 )

18
 R2: Measure of Dispersion around
the SCL
𝑅𝑅2 tells us how important the covariance risk is for explaining returns.

2 2
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
𝑅𝑅 = 𝜌𝜌 =
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉

2
𝛽𝛽𝑖𝑖,𝑀𝑀 𝜎𝜎𝑟𝑟2𝑀𝑀
𝑅𝑅2 = 2
𝛽𝛽𝑖𝑖,𝑀𝑀 𝜎𝜎𝑟𝑟2𝑀𝑀 + 𝜎𝜎𝑒𝑒2𝑖𝑖

19
 Problem with OLS 𝜷𝜷:
Infrequent trading
Dimson (1979) notes that when an asset is infrequently traded or when the
market portfolio (or any factor portfolio) is comprised of frequently and
infrequently traded assets, then 𝜷𝜷 is biased toward zero.

The solution is to use leads and lags of the factor:

𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖𝑡𝑡+1 𝑟𝑟𝑀𝑀,𝑡𝑡+1 − 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖𝑡𝑡 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖𝑡𝑡−1 𝑟𝑟𝑀𝑀,𝑡𝑡−1 − 𝑟𝑟𝑓𝑓 + 𝜀𝜀𝑖𝑖,𝑡𝑡

And the corrected 𝜷𝜷 is:

𝜷𝜷 = 𝛽𝛽𝑖𝑖𝑡𝑡+1 + 𝛽𝛽𝑖𝑖𝑡𝑡 + 𝛽𝛽𝑖𝑖𝑡𝑡−1

20
 Problem with OLS 𝜷𝜷, Past ≠ Future
Betas tend to mean revert:

21
 Predicting Betas:
Correcting for Mean Reversion
2 1
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝛽𝛽 = × 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻 𝑂𝑂𝑂𝑂𝑂𝑂 𝛽𝛽 + × 1
3 3
Why 1?
• Because the average 𝛽𝛽 in the market is 1

This is also a shrinkage estimator

• “raw estimate is improved by combining it with other information”
• There are other shrinkage estimators for variances and covariances, but
these are beyond the scope of this subject

22
 Markowitz Model:
How do we estimate
variances and
covariances?

23
Uses of Index
Models

• Calculating 𝛽𝛽, 𝛼𝛼, and 𝑅𝑅2

• Reducing Dimensionality
• Security and
Performance Analysis
24
 Index Models with
Markowitz Portfolio Theory
Suppose you want to plot the efficient frontier:

Efficient Trade-off Line & Efficent Frontier Curve

25%

20%
Expected Return

15%

10%

5%

0%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
25
 Reducing Dimensionality with
Index Models
You need to calculate portfolio expected returns and variances and find the
minimum:

𝑁𝑁

𝐸𝐸 𝑟𝑟𝑝𝑝̃ = � 𝑤𝑤𝑖𝑖 𝐸𝐸 𝑟𝑟𝑖𝑖̃

𝑖𝑖=1

𝑁𝑁 𝑁𝑁 𝑁𝑁

𝜎𝜎𝑝𝑝2 = � 𝑤𝑤𝑖𝑖2 𝜎𝜎𝑖𝑖2 + � � 𝑤𝑤𝑖𝑖 𝑤𝑤𝑗𝑗 𝜎𝜎𝑖𝑖,𝑗𝑗

𝑖𝑖=1 𝑖𝑖=1 𝑗𝑗=1
𝑗𝑗≠𝑖𝑖

26
 Dimensionality grows
exponentially with n
With only 10 assets you have a variance-covariance matrix with 100 element:

𝜎𝜎1,1 𝜎𝜎1,2 𝜎𝜎1,3 𝜎𝜎1,4 𝜎𝜎1,5 𝜎𝜎1,6 𝜎𝜎1,7 𝜎𝜎1,8 𝜎𝜎1,9 𝜎𝜎1,10
𝜎𝜎2,1 𝜎𝜎2,2 𝜎𝜎2,3 𝜎𝜎2,4 𝜎𝜎2,5 𝜎𝜎2,6 𝜎𝜎2,7 𝜎𝜎2,8 𝜎𝜎2,9 𝜎𝜎2,10
𝜎𝜎3,1 𝜎𝜎3,2 𝜎𝜎3,3 𝜎𝜎3,4 𝜎𝜎3,5 𝜎𝜎3,6 𝜎𝜎3,7 𝜎𝜎3,8 𝜎𝜎3,9 𝜎𝜎3,10
𝜎𝜎4,1 𝜎𝜎4,2 𝜎𝜎4,3 𝜎𝜎4,4 𝜎𝜎4,5 𝜎𝜎4,6 𝜎𝜎4,7 𝜎𝜎4,8 𝜎𝜎4,9 𝜎𝜎4,10
𝜎𝜎5,1 𝜎𝜎5,2 𝜎𝜎5,3 𝜎𝜎5,4 𝜎𝜎5,5 𝜎𝜎5,6 𝜎𝜎5,7 𝜎𝜎5,8 𝜎𝜎5,9 𝜎𝜎5,10
𝜎𝜎6,1 𝜎𝜎6,2 𝜎𝜎6,3 𝜎𝜎6,4 𝜎𝜎6,5 𝜎𝜎6,6 𝜎𝜎6,7 𝜎𝜎6,8 𝜎𝜎6,9 𝜎𝜎6,10
𝜎𝜎7,1 𝜎𝜎7,2 𝜎𝜎7,3 𝜎𝜎7,4 𝜎𝜎7,5 𝜎𝜎7,6 𝜎𝜎7,7 𝜎𝜎7,8 𝜎𝜎7,9 𝜎𝜎7,10
𝜎𝜎8,1 𝜎𝜎8,2 𝜎𝜎8,3 𝜎𝜎8,4 𝜎𝜎8,5 𝜎𝜎8,6 𝜎𝜎8,7 𝜎𝜎8,8 𝜎𝜎8,9 𝜎𝜎8,10
𝜎𝜎9,1 𝜎𝜎9,2 𝜎𝜎9,3 𝜎𝜎9,4 𝜎𝜎9,5 𝜎𝜎9,6 𝜎𝜎9,7 𝜎𝜎9,8 𝜎𝜎9,9 𝜎𝜎9,10
𝜎𝜎10,1 𝜎𝜎10,2 𝜎𝜎10,3 𝜎𝜎10,4 𝜎𝜎10,5 𝜎𝜎10,6 𝜎𝜎10,7 𝜎𝜎10,8 𝜎𝜎10,9 𝜎𝜎10,10

• You have to estimate 55 = 1⁄2 10 × 10 − 10 + 10 unique variances and

covariances

• Generalised: n variance terms + n (n-1) / 2 covariance terms

– E.g., n = 1,000  ~500,000 covariance terms
27
 Reducing Dimensionality with
Index Models
The index model implies that the covariance between any assets 𝑖𝑖 and 𝑗𝑗 is:
𝐶𝐶𝑜𝑜𝑜𝑜 𝑟𝑟𝑖𝑖,𝑡𝑡 , 𝑟𝑟𝑗𝑗,𝑡𝑡 = 𝐶𝐶𝐶𝐶𝐶𝐶 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖,𝑀𝑀 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 + 𝑒𝑒𝑖𝑖,𝑡𝑡 , 𝛼𝛼𝑗𝑗 + 𝛽𝛽𝑗𝑗,𝑀𝑀 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 + 𝑒𝑒𝑗𝑗,𝑡𝑡

𝐶𝐶𝐶𝐶𝐶𝐶 𝑟𝑟𝑖𝑖,𝑡𝑡 , 𝑟𝑟𝑗𝑗,𝑡𝑡 = 𝛽𝛽𝑖𝑖,𝑀𝑀 𝛽𝛽𝑗𝑗,𝑀𝑀 𝜎𝜎𝑟𝑟2𝑀𝑀

With 1,000 stocks and 1 factor:

• need to estimate 1,000 variances + 1,000 Betas + 1 index variance
instead of half a million estimates of variance and covariance

Single-index Model: simpler method to generate variances and covariances

28
 Portfolio Return according to
Single-Index Model
𝑟𝑟𝑃𝑃 − 𝑟𝑟𝑓𝑓 = 𝛼𝛼𝑃𝑃 + 𝛽𝛽𝑃𝑃 (𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 ) + 𝑒𝑒𝑃𝑃

1 𝑁𝑁
𝛽𝛽𝑃𝑃 = Σ 𝛽𝛽 ,
𝑁𝑁 𝑖𝑖=1 𝑖𝑖
1 𝑁𝑁
𝛼𝛼𝑃𝑃 = Σ𝑖𝑖=1 𝛼𝛼𝑖𝑖 ,
𝑁𝑁
1 𝑁𝑁
𝑒𝑒𝑃𝑃 = Σ𝑖𝑖=1 𝑒𝑒𝑖𝑖 ≈ 0
𝑁𝑁
𝑎𝑎𝑎𝑎 𝑁𝑁 → ∞

When N is large:
𝑟𝑟𝑃𝑃 − 𝑟𝑟𝑓𝑓 = 𝛼𝛼𝑃𝑃 + 𝛽𝛽𝑃𝑃 (𝑟𝑟𝑀𝑀 − 𝑟𝑟𝑓𝑓 )

29
 Portfolio Risk according to Single-
Index Model
𝜎𝜎𝑃𝑃2 = 𝛽𝛽𝑃𝑃2 𝜎𝜎𝑀𝑀
2
+ 𝜎𝜎 2 𝑒𝑒𝑃𝑃

𝑁𝑁

𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) = � 𝑤𝑤𝑖𝑖2 𝜎𝜎𝑒𝑒2𝑖𝑖

𝑖𝑖=1
Note: by construction 𝐶𝐶𝐶𝐶𝐶𝐶 𝜀𝜀𝑖𝑖 , 𝜀𝜀𝑗𝑗 = 0 ∀ 𝑖𝑖 ≠ 𝑗𝑗

As 𝑁𝑁 → ∞,
𝑤𝑤𝑖𝑖2 → 0,
and therefore 𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) → 0

𝝈𝝈𝟐𝟐𝑷𝑷 = 𝜷𝜷𝟐𝟐𝑷𝑷 𝝈𝝈𝟐𝟐𝑴𝑴

• Only systematic risk remains 30
 Security Performance Analysis
𝑟𝑟𝑖𝑖,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 = 𝛼𝛼𝑖𝑖 + 𝛽𝛽𝑖𝑖 𝑟𝑟𝑀𝑀,𝑡𝑡 − 𝑟𝑟𝑓𝑓,𝑡𝑡 + 𝜀𝜀𝑖𝑖,𝑡𝑡
Where does 𝛼𝛼𝑖𝑖 > 0 come from?
• Luck
– Ex. Atlas Pearls (ASX: ATP) blows up because Rihanna was seen wearing
them during the measurement period.
– The sample period for OLS was too short and 𝛼𝛼𝑖𝑖 ≠ 0 is a statistical fluke
• Good management of a firm
– The CEO is able to run the company more efficiently than expected
• Markets are inefficient and a portfolio manager picks assets well
– with better-than-expected managers or lucky ones
– Markets are efficient, but a portfolio manager times the market well
• Unmodeled risk factor
– The true asset pricing model includes other risk factors 31
 What if there are
additional sources of
risk besides the
market?

32
Multifactor
Models

• Data driven models

• APT

33
 More than just Market Risk
Problem with Single-Index Model/CAPM: There could be more sources of
systematic risk than just market risk
Solution: use a multifactor model:
𝐾𝐾

𝐸𝐸 𝑟𝑟𝑖𝑖̃ − 𝑟𝑟𝑓𝑓 = 𝛽𝛽𝑖𝑖,𝑀𝑀 𝐸𝐸 𝑟𝑟𝑀𝑀

̃ − 𝑟𝑟𝑓𝑓 + � 𝛽𝛽𝑖𝑖,𝑘𝑘 𝐸𝐸 𝑟𝑟𝐹𝐹𝑘𝑘
̃ − 𝑟𝑟𝑓𝑓
𝑘𝑘=1
where 𝑟𝑟𝐹𝐹𝑘𝑘
̃ is the return on the kth factor

A factor that can be anything that

• Reflects wealth: Labor market income, Housing value, Small business
• Affects wealth: unexpected inflation, changes in industrial production, many
more possibilities
• To date, more than 300 different factors have been proposed
34
 A general note about factors
Factors should affect the average investor.
• Consider a risk that in the future makes A better off and B worse off
– B sells the risk
– A buys it
• Net effect is zero.

This helps explains why LOTS of variables are correlated with returns, but do not
carry any priced risk
• For example: Industry returns comove, but not once you control for priced
risks.

35
The Fama-
French 3-
Factor Model
• A data-driven factor
model

36
 Fama and French (1992)

Problem: CAPM 𝜷𝜷 doesn’t seem to be associated with returns

37
 𝛼𝛼𝑖𝑖 > 0 for Small and Value stocks
Research has identified portfolios of stock with 𝛼𝛼𝑖𝑖 > 0:
• Small firms (low market equity) outperform large firms
– at least they did 1926 through 1980
• Value (high book-to-market) stocks outperform Glamour/Growth stocks

38
Table from Fama and French (1992)
 Fama-French Three Factor Model
𝐸𝐸 𝑟𝑟𝑖𝑖̃ − 𝑟𝑟𝑓𝑓 = 𝛽𝛽𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑟𝑟𝑀𝑀 � + 𝛽𝛽𝐻𝐻𝐻𝐻𝐻𝐻,𝑖𝑖 𝐸𝐸 𝐻𝐻𝐻𝐻𝐻𝐻
̃ − 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑆𝑆𝑀𝑀𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑆𝑆𝑆𝑆𝑆𝑆 �

Market Risk Premium

SMB is a portfolio long Small stocks and short large or Big stocks
• SMB for Small Minus Big

HML is a portfolio long Value stocks and short Growth stocks

• (value stocks are called “High book to market” stocks, by finance professor
types and Growth stocks are called “Low book to market” stocks.
• HML is High Minus Low.

39
 Other data-driven factor models
Carhart 4-factor model

𝐸𝐸 𝑟𝑟𝑖𝑖̃ − 𝑟𝑟𝑓𝑓 = 𝛽𝛽𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑟𝑟𝑀𝑀 �

̃ − 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑆𝑆𝑀𝑀𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑆𝑆𝑆𝑆𝑆𝑆
� + 𝛽𝛽𝑊𝑊𝑀𝑀𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑊𝑊𝑀𝑀𝑀𝑀
+𝛽𝛽𝐻𝐻𝐻𝐻𝐻𝐻,𝑖𝑖 𝐸𝐸 𝐻𝐻𝐻𝐻𝐻𝐻 �

• Controls for “momentum” (WML: “winners minus losers”)

Fama-French 5-factor model

� + 𝛽𝛽𝐻𝐻𝐻𝐻𝐻𝐻,𝑖𝑖 𝐸𝐸 𝐻𝐻𝐻𝐻𝐻𝐻
̃ − 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑆𝑆𝑀𝑀𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑆𝑆𝑆𝑆𝑆𝑆
𝐸𝐸 𝑟𝑟𝑖𝑖̃ − 𝑟𝑟𝑓𝑓 = 𝛽𝛽𝑀𝑀,𝑖𝑖 𝐸𝐸 𝑟𝑟𝑀𝑀 �
�
+𝛽𝛽𝑅𝑅𝑅𝑅𝑅𝑅,𝑖𝑖 𝐸𝐸 𝑅𝑅𝑅𝑅𝑅𝑅 + 𝛽𝛽𝐶𝐶𝐶𝐶𝐶𝐶,𝑖𝑖 𝐸𝐸 𝐶𝐶𝑀𝑀𝐴𝐴

• Adds “Investment” and “Profitability” factors

40
Arbitrage
Pricing Theory
(APT)

Ross (1976)

41
 APT Security Market Line
If Assumptions 1 to 3 on the next slide hold, then the APT states that the
expected return on a well-diversified portfolio P is:
𝐾𝐾

𝐸𝐸 𝑟𝑟𝑃𝑃̃ = 𝑟𝑟𝑓𝑓 + � 𝛽𝛽𝑃𝑃,𝑘𝑘 (𝐸𝐸[𝑟𝑟𝐹𝐹𝐹𝐹

̃ ] − 𝑟𝑟𝑓𝑓 )
𝑘𝑘=1
̃ is the return on factor k
where 𝑟𝑟𝐹𝐹𝐹𝐹

• This looks like the CAPM SML equation (assets with the same beta should
have the same expected return)
• but with multiple factors
• and much fewer assumptions

42
 APT Assumptions
A1: Realised returns can be described by a factor structure:
𝐾𝐾

𝑟𝑟𝑖𝑖̃ = 𝐸𝐸 𝑟𝑟𝑖𝑖̃ + � 𝛽𝛽𝑖𝑖,𝑘𝑘 𝐹𝐹�𝑘𝑘 + 𝑒𝑒̃𝑖𝑖

𝑘𝑘=1

• 𝐹𝐹�𝑘𝑘 is the mean-zero unanticipated component of factor k

• 𝑒𝑒̃𝑖𝑖 is the mean-zero idiosyncratic risk of asset i

A2: There are a sufficiently large numbers of securities to allow the creation of
well-diversified portfolios in which idiosyncratic risk is eliminated

A3: There are no arbitrage opportunities

These assumptions imply a K-factor model:

𝐾𝐾

𝐸𝐸 𝑟𝑟𝑃𝑃̃ = 𝑟𝑟𝑓𝑓 + � 𝛽𝛽𝑃𝑃,𝑘𝑘 (𝐸𝐸[𝑟𝑟𝐹𝐹𝐹𝐹

̃ ] − 𝑟𝑟𝑓𝑓 ) 43
𝑘𝑘=1
 Why portfolios in APT?
Suppose that a single factor 𝐹𝐹� explains returns
Then:
𝜎𝜎𝑃𝑃2 = 𝛽𝛽𝑃𝑃2 𝜎𝜎𝐹𝐹2 + 𝜎𝜎 2 𝑒𝑒𝑃𝑃

The variance of the portfolio’s idiosyncratic risk eP is

𝑁𝑁

𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) = � 𝑤𝑤𝑖𝑖2 𝜎𝜎𝑒𝑒2𝑖𝑖

𝑖𝑖=1
Note: by construction 𝐶𝐶𝐶𝐶𝐶𝐶 𝜀𝜀𝑖𝑖 , 𝜀𝜀𝑗𝑗 = 0 ∀ 𝑖𝑖 ≠ 𝑗𝑗

As 𝑁𝑁 → ∞, 𝑤𝑤𝑖𝑖2 → 0, and therefore 𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) → 0

Implication: APT holds exactly for well-diversified portfolio and inexactly for 44

portfolios that are not well diversified and individual stocks.

 Portfolio Returns
APT Assumption 1 states that returns follow a factor structure:

𝑟𝑟𝑃𝑃̃ = 𝐸𝐸 𝑟𝑟𝑃𝑃̃ + 𝛽𝛽𝑃𝑃 𝐹𝐹� + 𝑒𝑒̃𝑃𝑃

But 𝐸𝐸[𝑒𝑒̃𝑃𝑃 ] = 0 (since 𝐸𝐸[𝑒𝑒̃𝑖𝑖 ] = 0 for all the stocks it holds) and 𝜎𝜎 2 (𝑒𝑒𝑃𝑃 ) → 0 as N
increases…
• So the 𝑒𝑒̃𝑃𝑃 term drops out
• Which implies

𝑟𝑟𝑃𝑃̃ = 𝐸𝐸 𝑟𝑟𝑃𝑃̃ + 𝛽𝛽𝑃𝑃 𝐹𝐹�

45
 Putting the “Arbitrage” in the
Arbitrage Pricing Theory
An arbitrage strategy is one that takes no risk and requires no wealth but
generates a profit

Consider two portfolios A and B, both with beta = 1

APT claims that portfolios with the same beta must have same expected returns

But suppose that, contrary to APT claim, A and B have different expected
returns:
𝐸𝐸 𝑟𝑟𝐴𝐴̃ = 10% and 𝐸𝐸 𝑟𝑟̃ 𝐵𝐵 = 8%

Claim: There is an arbitrage opportunity

46
 𝑟𝑟𝐴𝐴̃ versus 𝑟𝑟𝐵𝐵̃
Given that these are well-diversified portfolios and that their returns follow a
factor structure, the next period actual returns of the portfolios are
𝑟𝑟𝐴𝐴̃ = 𝐸𝐸 𝑟𝑟𝐴𝐴̃ + 𝛽𝛽𝐴𝐴 𝐹𝐹� = 10% + 𝐹𝐹�

𝑟𝑟𝐵𝐵̃ = 𝐸𝐸 𝑟𝑟𝐵𝐵̃ + 𝛽𝛽𝐵𝐵 𝐹𝐹� = 8% + 𝐹𝐹�

(The 𝑒𝑒̃ terms have dropped out, since these are well-diversified portfolios)

• According to the pricing equations, 𝐹𝐹� determines the returns on A and B

• But 𝐹𝐹� is the same for both portfolios
• Which implies 𝑟𝑟𝐴𝐴̃ > 𝑟𝑟𝐵𝐵̃ no matter what 𝐹𝐹� is:
𝑟𝑟𝐴𝐴̃ − 𝑟𝑟𝐵𝐵̃ = 10% + 𝐹𝐹� − 8% + 𝐹𝐹� = 2%

47
𝑟𝑟𝐴𝐴̃ > 𝑟𝑟𝐵𝐵̃ regardless of 𝐹𝐹�

48
 Executing the Arbitrage
Short portfolio B and go long portfolio A, making a riskless profit
For example, sell short $1b of B and buy long $1b of A
• Ignoring other costs, this costs you $0 today
• According to the APT, it will yield $1b × (𝑟𝑟𝐴𝐴̃ −𝑟𝑟𝐵𝐵̃ ) = $1b × 2% = $20m
regardless of the realisation of F

An investor who notices the mispricing will try to take as a large a long-short
position as possible
• The price of B decreases, pushing up 𝐸𝐸 𝑟𝑟𝐵𝐵̃
• The price of A increases, pushing down 𝐸𝐸 𝑟𝑟𝐴𝐴̃
The arbitrage disappears when the two assets with the same beta have the
same expected return
49
 Arbitrage is the power of APT
Key to APT: well diversified portfolios requiring no wealth should earn no return

APT says that all portfolios must follow the Law of One Price:
2 portfolios with the same risk and the same cash flows must have the same
price
If they do not, arbitrageurs will short sell the expensive one (i.e., lower 𝐸𝐸[𝑟𝑟])
̃
and buy the cheap one (i.e., higher 𝐸𝐸[𝑟𝑟])
̃ until the prices correct

No restrictive assumptions about returns or preferences

• Just need one or several people who understand the underlying risk factors
and can arbitrage the mispricing

50
 What about portfolios with
different betas?
For such portfolios, the risk premium must be proportional to beta
• Otherwise, arbitrage opportunities will exist

Suppose we have two portfolios:

• Portfolio A: βA = 1 and 𝐸𝐸 𝑟𝑟𝐴𝐴̃ = 10%
• Portfolio C: βC = 0.5 and 𝐸𝐸 𝑟𝑟𝐶𝐶̃ = 6%

A and C have different expected returns

• But they also have different betas
• Can’t directly compare them to determine if an arbitrage opportunity exists

51
 Create a portfolio with equivalent
beta
Suppose rf = 4%

One approach: construct portfolio D with A and the risk-free asset such that D
has the same beta as C (0.5):
• 50% in A and 50% in the risk-free asset

𝛽𝛽𝐷𝐷 = 0.5 ⋅ 1 + 0.5 ⋅ 0 = 0.5 = 𝛽𝛽𝐶𝐶

𝐸𝐸 𝑟𝑟𝐷𝐷̃ = 0.5 ⋅ 10% + 0.5 ⋅ 4% = 7% > 𝐸𝐸 𝑟𝑟𝐶𝐶̃

• Arbitrage Strategy: Long D, Short C

52
Arbitrage with different betas

53
An Arbitrage
Cookbook

54
 APT in a one-factor economy
Suppose expected returns for any well diversified portfolio, P, have a 1 factor
structure (and that factor is the market), but the portfolio is mispriced:
𝐸𝐸 𝑟𝑟𝑃𝑃̃ − 𝑟𝑟𝑓𝑓 = 𝛼𝛼𝑃𝑃 + 𝛽𝛽𝑃𝑃 𝐸𝐸 𝑟𝑟𝑀𝑀
̃ − 𝑟𝑟𝑓𝑓
.30
P SML
.25 𝐸𝐸[𝑟𝑟̃ 𝑃𝑃]
Expected Return

.20
αP>0
.15
.10
.05
.00
-1 -0.5 0 0.5 βP 1 1.5 2 2.5
55
Beta
 Intuition of Arbitrage
Create a long-short portfolio from the mispriced portfolio and other well-
diversified portfolios that has no risk.
• The betas with respect to each risk factor are zero.
– Implying the long-short portfolio earns the risk-free rate.

If the zero beta long-short portfolio is cheap:

• Borrow at the risk-free rate and buy it
If the zero beta long-short portfolio is expensive:
• Short sell the long-short portfolio and invest in the risk-free asset

NOTE: the following example is only one way to implement this intuition.

56
 An Arbitrage Example
β𝑃𝑃 = .6, 𝑟𝑟𝑓𝑓 = .06 𝐸𝐸 𝑟𝑟̃ 𝑀𝑀 = 0.14
APT 𝐸𝐸 𝑟𝑟̃ 𝑃𝑃 = 0.108
actual 𝐸𝐸 𝑟𝑟̃ 𝑃𝑃 = 0.25 Implying α= .142

We need at least 2 well diversified risky portfolios (at least 1 should be

mispriced)

Let’s use:
• Mispriced portfolio P
• The market portfolio

57
 An Arbitrage Cookbook
1. Calculate weights to create a portfolio with a beta of zero toward each
factor (i.e. no risk)
𝛽𝛽𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑤𝑤𝑃𝑃 𝛽𝛽𝑃𝑃 + 𝑤𝑤𝑀𝑀 𝛽𝛽𝑀𝑀 + 𝑤𝑤𝐹𝐹 𝛽𝛽𝐹𝐹 = 0
0.6𝑤𝑤𝑃𝑃 + 1𝑤𝑤𝑀𝑀 + 0𝑤𝑤𝐹𝐹 = 0
𝑤𝑤𝑀𝑀 = −0.6𝑤𝑤𝑃𝑃
Note: If there are multiple factors, then repeat for each factor.

2. Create a portfolio that requires zero wealth by making sure all the weights
sum to zero
𝑤𝑤𝑃𝑃 + 𝑤𝑤𝑀𝑀 + 𝑤𝑤𝐹𝐹 = 0
𝑤𝑤𝑃𝑃 − 0.6𝑤𝑤𝑃𝑃 + 𝑤𝑤𝐹𝐹 = 0
𝑤𝑤𝐹𝐹 = −0.4𝑤𝑤𝑃𝑃

58
 An Arbitrage Cookbook (cont.)
3. Set one of the weights as the numeraire (i.e. just set one of them to 1)
• Let’s arbitrarily pick portfolio P, implying:
𝑤𝑤𝑃𝑃 = 1 𝑤𝑤𝑀𝑀 = −0.6 𝑤𝑤𝐹𝐹 = −0.4

4. Check the sign of the returns to the arbitrage:

𝐸𝐸 𝑟𝑟𝑍𝑍𝑍𝑍𝑍𝑍𝑍𝑍−𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
̃ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑤𝑤𝑃𝑃 𝐸𝐸 𝑟𝑟𝑃𝑃
̃ + 𝑤𝑤𝑀𝑀 𝐸𝐸 𝑟𝑟𝑀𝑀
̃ + 𝑤𝑤𝐹𝐹 𝑟𝑟𝐹𝐹
𝐸𝐸 𝑟𝑟𝑍𝑍𝑍𝑍𝑍𝑍𝑍𝑍−𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
̃ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 1 × 25% − 0.6 × 14% − 0.4 × 6%
𝐸𝐸 𝑟𝑟𝑍𝑍𝑍𝑍𝑍𝑍𝑍𝑍−𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
̃ 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 25% − 8.4% − 2.4% = 14.2%

The sign is positive (14.2% > 0), so the weights have the correct sign. If the sign
were negative, then flip the sign on the weights.

59
 An Arbitrage Example Concluded
With weights of
𝑤𝑤𝑃𝑃 = 1 𝑤𝑤𝑀𝑀 = −0.6 𝑤𝑤𝐹𝐹 = −0.4

A portfolio that
• shorts the market for $0.60 and
• borrows at the risk-free $0.40 and
• invests that $1 in portfolio P
will earn 14.2% × $1 = $0.142.

This method generalizes to multiple factors.

• You will see that on your Practice Questions for Week 8.

60
 APT factors?
APT is agnostic about factors. They can be:
Statistical: analyses of covariance of returns to uncover factors
• We will leave this to your quant/stat subjects

Fundamentals: firm characteristics that reflect exposure to systematic risks

• Accounting ratios (market to book, price to earnings, size, …)
• Liquidity
• Leverage

Macroeconomic
• Market portfolio, growth in industrial production
• Inflation, term premium (10-year minus 1-year govn’t bond yields).
• Default premium 61
 Key Questions
Realised returns and risk can be separated in to two types, what are they?
What determines whether a risk is compensated factor?
What is the compensation for holding idiosyncratic risk?
How does APT differ from CAPM?

62
 COMMONWEALTH OF AUSTRALIA

Copyright Regulations 1969

Warning

This material has been reproduced and communicated to you by

or on behalf of the University of Melbourne pursuant to Part VB
of the Copyright Act 1968 (the Act).

The material in this communication may be subject to copyright

under the Act. Any further copying or communication of this
material by you may be the subject of copyright protection
under the Act.

Do not remove this notice