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APT Slides
1
Learning Objectives: Arbitrage Pricing Theory and
Multifactor Models of Risk and Return (Bodie Chap 10)
• Describe the inputs, including factor betas, to a multi factor model.
• Calculate the expected return of an asset using a single-factor and a
multi-factor model.
• Describe properties of well-diversified portfolios and explain the impact of
diversification on the residual risk of a portfolio.
• Explain how to construct a portfolio to hedge exposure to multiple factors.
• Describe and apply the Fama-French three factor model in estimating
asset returns.
2
Describe the inputs, including factor betas, to a multi
factor model.
= + +
3
Describe the inputs, including factor betas, to a multi
factor model (continued)
= + +
Notes:
• The macro factor has a zero expectation: it represents changes in these
variables that have not already been anticipated
• The firm-specific component of unexpected return, also has zero
expected value.
• If the macro factor has a value of zero (0) in any particular period, the
return on the security will equal its previously expected value, , plus
the effect of firm-specific events only.
• The nonsystematic component of returns or the firm specific events ( s)
are assumed to be uncorrelated among themselves and uncorrelated with
the factor ( ).
4
Describe the inputs, including factor betas, to a multi
factor model (continued)
A multi-factor model should be better
The systematic risk premium or extra market sources of risk may arise
from several sources; e.g., uncertainty about interest rates, inflation,
business cycle uncertainty, etc.
• Single-factor models lump all systematic sources of risk into one variable
5
Describe the inputs, including factor betas, to a multi
factor model (continued)
= + + +
For example, if there are two sources of macro risk, say the business cycle
uncertainty, as measured by unanticipated growth in GDP and unexpected
changes in interest rates (IR), then the return on a stock will respond both to
sources of macro risk (GDP and IR) and to its own firm-specific influences( ).
= + + +
6
Describe the inputs, including factor betas, to a multi
factor model (continued)
Factor Factor
Sensitivity Sensitivity
= + + +
Systematic Systematic
factor factor
• The two macro factors (on the right-hand side of the equation) are the
systematic factors in the economy. As in the single-factor model, both
of these macro factors represent changes in these variables that have
not already been anticipated and so have an expected value of zero.
• The coefficients of each factor measure the sensitivity of share returns to
that factor. This is why the coefficients are sometimes called factor
sensitivities, factor loadings, or, equivalently, factor betas.
7
Describe the inputs, including factor betas, to a multi
factor model (continued)
Generalizing to multiple factors: We can generalize the two-factor model
to one with multiple ( ) factors but note this remains a linear model:
= + + +. . . + +
8
Calculate the expected return of an asset
using a single-factor and a multi-factor model.
Single–factor model
Bodies Example 10.1: Suppose that the macro factor is news about the
state of the business cycle, measured by the unexpected percentage
change in GDP. The stock is currently expected to earn a 10% rate of
return, and that the consensus is that GDP will increase by 4% this
year and the stock’s sensitivity, to changes in GDP is 1.20.
• Suppose two scenarios of actual growth in GDP versus expected growth:
GDP increases by only 3% (lower than expected), or
GDP growth is 5% (higher than expected).
• We can the estimate of the stock’s new expected rate of return as:
= . + . ( )+
9
Calculate the expected return of an asset
using a single-factor and a multi-factor model
In the first scenario, GDP growth is lower by 1% (Actual
– Expected = 3% - 4%). This unexpected decrease in GDP translates into a
1.2% ( = 1.2 × -1%) lower return than previously expected. So, we revise
the stock’s expected rate of return downwards from 10% to 9.2% (Note:
The error term has zero expected value)
= %+ . × %− % = %− . %= . %
= %+ . × %− %= %+ . %= . %
10
Calculate the expected return of an asset
using a single-factor and a multi-factor model.
Multi–factor model
Bodies end of chapter (EOC) Problem 1: Suppose that two factors have
been identified for the U.S. economy: the growth rate of industrial
production, IP, and the inflation rate, IR. IP is expected to be 3%, and IR
5%. A stock with a beta of 1.0 on IP and 0.5 on IR currently is expected to
provide a rate of return of 12%. If industrial production actually grows by
5%, while the inflation rate turns out to be 8%, what is your revised estimate
of the expected rate of return on the stock?
Given the data, the multifactor model of excess returns can be stated as:
= . + . + . ( ) +
11
Calculate the expected return of an asset
using a single-factor and a multi-factor model
As shown in the table, when IP grows by 5% (instead of 3%) and IR by 8%
(instead of 5%), the excess returns on the stock can be calculated as:
= %+ . %− % + . %− %
= %+ . %+ . %= . %
12
Describe properties of well-diversified portfolios and explain
the impact of diversification on the residual risk of a portfolio.
= ( )+ +
13
Describe properties of well-diversified portfolios and explain
the impact of diversification on the residual risk of a portfolio
(continued)
= + ( )
where is the variance of the factor F and ( ) is the nonsystemic risk of the
portfolio, which is given by
= ( )= ( )
14
Describe properties of well-diversified portfolios and explain
the impact of diversification on the residual risk of a portfolio
(continued)
1 1 1
= Variance( )= 2 = = ( )
15
Describe properties of well-diversified portfolios and explain
the impact of diversification on the residual risk of a portfolio
(continued)
%
= + = . % +
→ . =
% . %
16
Describe properties of well-diversified portfolios and explain
the impact of diversification on the residual risk of a portfolio
(continued)
17
Explain how to construct a portfolio to hedge exposure to
multiple factors
Let the factor exposures of a well-diversified portfolio, , be given by its betas,
and . A portfolio can be formed by investing in factor portfolios with the
following weights: in the first factor portfolio, in the second factor
portfolio, and 1 − − in the T-bills (risk-free rate). By construction,
portfolio Q will have betas equal to those of portfolio P and expected return of:
( )= ( )+ ( )+( − − )
= + [ ( )− ]+ [ ( )− ]
( )= + + + ⋯+
18
Explain how to construct a portfolio to hedge
exposure to multiple factors (continued)
Bodie Example 10.4: Suppose two factor portfolios have expected returns
= 10% and = 12%. The risk-free rate( ) is 4%. Now consider a
well-diversified portfolio, with beta on the first factor equal to 0.50 and beta
on the second factor equal to 0.75.
• The portfolio’s risk premium due to first factor is: 0.50 ∗ (10.0% −
4.0%) = 3.0%
• The risk premium due to second risk factor is: 0.75 ∗ 12.0% − 4.0% =
6.0%
• Therefore, the total risk premium on the portfolio is 9.0% (=3.0% + 6.0%)
• The total return on the portfolio is 13.0% (= 4% + 9%) using multifactor
SML; i.e., 4.0% + 0.50 ∗ 10.0% − 4.0% + 0.75 ∗ 12.0% − 4.0% =
13.0%
19
Explain how to construct a portfolio to hedge
exposure to multiple factors
Bodie's Arbitrage Opportunity
It is Possible Because Security C lies below the SML
Arbitrage portfolio
Riskfree 0.00 4.0% 0.0%
Security (A) 1.00 10.0% 6.0%
0.50 7.0% 3.0% 0.060
20
Explain how to construct a portfolio to hedge
exposure to multiple factors (continued)
1. If T-bills currently offer a 6% yield, find the expected rate of return on this
stock if the market views the stock as fairly priced. The expected rate of
return of the stock using multifactor SML is
= + + +
= 6.0% + 1.2 × 6.0% + 0.50 × 8.0% + 0.3 × 3.0% = 18.10%
2. Suppose that the actual values turn out to be different from the market
expected values as shown in the table for the three macro factors,
calculate the revised expectations for the rate of return on the stock
once the “surprises” become known. Using multifactor model, the
revised return on the stock is
= + + +. . . + +
= 18.10% + 1.2 4.0% − 5.0% + 0.5 6.0% − 3.0% + 0.3 0.0% − 2.0%
= 17.80%
21
Explain how to construct a portfolio to hedge exposure to
multiple factors (continued)
Bodie EOC 10.10: Consider the following multifactor (APT) model of
security returns for a particular stock. (Factor, Factor Beta, Factor Risk
premiums, expected and actual market values are as given and shown in
the table below along with the calculations.)
22
Describe and apply the Fama-French three factor model
in estimating asset returns.
An alternative approach to specifying macroeconomic factors as candidates
for relevant sources of systematic risk uses firm characteristics that seem
on empirical grounds to proxy for exposure to systematic risk. The factors
chosen are variables that on past evidence seem to predict average returns
well and therefore may be capturing risk premiums.
One example of this approach is the Fama and French three-factor model,
which has come to dominate empirical research and industry applications:
= + + + +
Market
factor Size
Value
factor
(P/B)
factor
23
Describe and apply the Fama-French three factor model
in estimating asset returns (continued)
Where:
SMB = Small Minus Big, i.e., the return of a portfolio of small stocks in
excess of the return on a portfolio of large stocks.
HML = High Minus Low, i.e., 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.
Note that in this model the market index does play a role and is expected
to capture systematic risk originating from macroeconomic factors.
These two firm-characteristic variables are chosen because of long-standing
observations that corporate capitalization and book-to-market ratio predict
deviations of average stock returns from levels consistent with the CAPM.
The problem with empirical approaches such as the Fama-French model, which
use proxies for extramarket sources of risk, is that none of the factors in the
proposed models can be clearly identified as hedging a significant source of
uncertainty.
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The End
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