Arbitrage Pricing Theory

Chap 9 of Reilly and Brown and Chap.

Of Prasanna Chandra
 Limitations of CAPM
• The CAPM has been one of the most useful-
and frequently used- financial theories ever
developed.
• Still, the model has some deficiencies
• Some tests of CAPM indicated that the beta
for individual securities were not stable, but
portfolio betas were stable (with some
conditions)
 Limitations of CAPM
• Some studies find that firms give more return
than suggested with beta, for example low P/E
firms give more return than high P/E firms
after adjusting for risk as measured by beta
– High book-to-market price ratio firms generated
more return than low book-to-market price ratio
firms
• In efficient markets such return differential
should not exist
 Limitations cont..
• The explanations of such difference could be:
– Either the markets are not efficient
– Or the model (CAPM) that predicts such returns is
not accurate
• Markets are efficient in the long run, as
suggested by number of studies, so the only
logical conclusion is : CAPM is not accurate.
 Limitations cont…
• The CAPM captures only one form of risk, i.e.
systematic risk in terms of Beta
• CAPM is based on many assumptions which
are not true in practical life
To overcome these limitations, Stephen Ross
developed Arbitrage Pricing Theory (APT) which
requires less assumptions and it allows multiple
risk factors
 Assumptions of APT
• Capital markets are perfectly competitive
• Investors always prefer more wealth to less
wealth with certainty
• The stochastic process generating asset
returns can be expressed as a linear function
of a set of K risk factors (or indices)
 APT- Return generating Process
• The APT assumes that the return on asset is linearly
related to a set of risk factors as shown below:

Ri is the actual return on asset i during a specific time

period (i=1,2,…n)
E(Ri) is expected return on asset i if all the risk factors have
zero changes
bij is the sensitivities of asset i’s return to the common risk
factor j
ƍj is a set of common factors, with a zero mean, that
influences the return on all assets
ei is the random error term (a unique effect on i’s return)
 APT- cont
• ƍj are multiple risk factors expected to have an
impact on the returns of all assets.
• For example: GDP, inflation, political
upheavals, change in interest rate etc
• APT considers these all factors that may have
impact on return compared to CAPM which
considers only covariance of the asset with
market portfolio (beta)
 APT- cont
• Given those common factors, i.e. ƍ, the bij
determine how each asset reacts to the jth
particular common factor
• For example: Interest rate change will affect all
securities in the economy, but some securities
(like banking stocks) will have more impact
than other securities (like FMCG stocks)
 APT- Equilibrium risk-return relationship
• APT requires that in equilibrium the return on a zero-
investment, zero-systematic risk portfolio is zero when the
unique effects (εi) are diversified away [this is the basic
concept of arbitrage)
– The key idea that guides the development of equilibrium risk-
return relationship is the law of one price which says that two
identical things cannot sell at different prices
– Similarly, two portfolios having same risk, cannot offer different
returns
– If they offer so, arbitrageurs will step in and one price will be
established
• This assumption implies that the expected return on any
asset i can be expressed as
 APT-cont

Where:
λ0= the expected return on an asset with zero
systematic risk
λj= the risk premium related to the jth common
risk factor, ƍj
bij= the pricing relationship between the risk
premium and the asset; or the responsiveness
of the asset i to the jth common factor
 Comparing APT and CAPM
CAPM APT
Form of equation Linear Linear
Number of risk factors 1 K≥1
Factor risk premium E(Rm) – Rf Λj
Factor risk sensitivity βj Bij
Zero beta return (when no Rf λ0
systematic risk is present)
 Example 1
• Consider the following data for two risk factors (1 and
2) and two securities (J and L):
λ0= 0.05 bJ1=0.8
λ1=0.02 bJ2=1.40
λ2=0.04 bL1=1.6
bL2=2.25

– Compute the expected return for both the securities,

– Suppose that J is priced at $22.50 while L is at $15.00. It is
expected that both securities with pay $0.75 as dividend.
What is the expected price of both the securities?
– Suppose, somehow you know that after one year price of J
will be $24 and L will be $17. How can you benefit from
the situation?
 Example 2
Consider the following data for two stocks D
and E and two risk factors 1 and 2 What should the price of each stock be
today to be consistent with the
Stock bi1 bi2 E(Ri)
expected rate of return levels given?
D 1.2 3.4 13.1% c. Suppose now that the risk premium for
E 2.6 2.6 15.4% Factor 1 that you calculated in part a
suddenly increases by 0.25%. What
a. Assuming that the risk free rate is are the new expected returns for
5%, calculate the levels of the factor stocks D and E?
risk premia that are consistent with d. If the increase in the Factor 1 risk
the reported values for the factor premium in Part c does not cause you
betas and the expected returns for to change your opinion about what
the two stocks. the stock price be in one year, what
b. You expect that in one year the adjustment be necessary in the
prices for stock D and E will be $55 current price?
and $36 respectively. Also, neither
stock is expected to pay a dividend
over the next year.
 Example 3
• Suppose that three stocks (A, B and C) and two
common risk factors (1 and 2) have the following
relationship:

– a. If λ1=4% and λ2=2%, what are the prices expected

next year for each of the stocks? Assume that all three
stocks currently sell for $30 and will not pay a
dividend in the next year
– b. Suppose you know that next year the prices for
stock A, B and C will actually be $31.50, $35.00 and
$30.50. Create and demonstrate a riskless, arbitrage
investment to take advantage of these mispriced
securities. What is the profit from your investment?