INTERNATIONAL FINANCIAL

MANAGEMENT
Dr. Mihály Ormos
 WHAT WE HAVE SEEN SO FAR…
 Basic priciples of asset pricing
̵ Individual decisions
 rationality
 expected utility maximization
 risk aversion
̵ Markowitz portfolio theory
 utility maximization by efficient portfolio holding
̵ CAPM
 Simplifying assumptions
 CML, Characteristic line and SML
̵ Efficient market hypothesis
 forms, tests and conclusions
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 ARBITRAGE PRICING THEORY– APT
 Arbitrage – security mispricing in a way that risk-free profits can
be earned is called arbitrage.
 It involves the simultaneous purchase and sale of equivalent
securities in order to profit from their price discrepancies.
 The most basic principle of capital market theory is that
̵ equilibrium market prices are rational in that they rule out arbitrage
opportunities.
̵ If actual security prices allow for arbitrage, the result will be strong
pressure to restore equilibrium.
̵ Therefore, security markets ought to satisfy a “no-arbitrage condition.”
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 APT
 CAPM’s SML gives an explanation of risk and return relationship where risk is
measured by the beta parameter, the sensitivity to the market portfolio.
 APT similarly defines a relationship between risk and return; however,
̵ its derivation applies different techniques and built on different suppositions.
̵ We derive the relationship for well-diversified portfolios and show that these are priced in a
way that satisfies the CAPM – expected return-beta relationship.
̵ Furthermore, we derive a Security Market Line which is not rely on the unobservable,
theoretical market portfolio.
̵ First, we build an APT with one factor which we generalize to the multi-factor model.
̵ We also show that all single securities are almost certainly satisfies this condition.
̵ In the end of the day, we discuss the similarities and differences of the CAPM, the index-
model and the APT.

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 ARBITRAGE: PROFITS AND OPPORTUNITIES
 An arbitrage opportunity arises when an investor can earn riskless profits without
making a net investment.
̵ We have to create an „arbitrage portfolio”, a zero net investment portfolio.
 Trivial example of an arbitrage opportunity if prices violate the „Law of One Price”
̵ An arbitrage opportunity would arise if shares of a stock sold for different prices on two
different exchanges.
 suppose IBM sold for $195 on the NYSE but only $193 on NASDAQ.
 Then you could buy the shares on NASDAQ and simultaneously sell them on the NYSE, clearing
a riskless profit of $2 per share without tying up any of your own capital.
̵ You short sell on higher and buy on lower price, thus you do not invest any capital.
̵ The profit is positive while there is no risk at all, as the short and long positions are
equalizing each other.

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 LAW OF ONE PRICE
 The Law of One Price states that if two assets are equivalent in all economically
relevant aspects, then
̵ they should have the same market price.
 The Law of One Price is enforced by arbitrageurs:
̵ If they observe a violation of the law, they will engage in arbitrage activity
̵ simultaneously buying the asset where it is cheap and selling where it is expensive.
̵ In the process, they will bid up the price where it is low and force it down where it is high
until the arbitrage opportunity is eliminated.
 The idea that market prices will move to rule out arbitrage opportunities is
perhaps the most fundamental concept in capital market theory.
 Violation of this restriction would indicate the highest level of market
irrationality.
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 A FOUR SHARES WORLD
 Returns: High Interest Rate Low Interest Rate
High Inflation Low Inflation High Inflation High Inflation
Probability 0,25 0,25 0,25 0,25
Apex (A) -20 20 40 60
Bull (B) 0 70 30 -20
Crush (C) 90 -20 -10 70
Dreck (D) 15 23 15 36
 Prices and Returns:
Correlation Matrix
Expected Standard
Share Price ($)
Return Dev. (%) A B C D
A 10 25 29,58 1,00 -0,15 -0,29 0,68
B 10 20 33,91 -0,15 1,00 -0,87 -0,38
C 10 32,5 48,15 -0,29 -0,87 1,00 0,22
D 10 22,25 8,58 0,68 7 -0,38 0,22 1,00
 Return data do not indicate any arbitrage opportunity.
 Expected returns, standard deviations, and correlations show no particular abnormality.

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 LET WE THINK…
 Let’s look at an equally weighted portfolio of the first three stocks and compare its potential future
return with the return on the fourth stock, Dreck.
High Interest Rate Low Interest Rate
High Inflation Low Inflation High Inflation High Inflation
Equally weighted (A, B, C)
23,33 23,33 20 36,67
portfiolio
Dreck (D) 15 23 15 36
 Our equally weighted portfolio outperforms Dreck in all four possible market situations (states of the
economy).
Average Standard Dev. Correlation
Equally weighted (A, B, C) portfiolio 25,83 6,40
0,94
Dreck (D) 22,25 8,58
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 The two investments are not perfectly correlated, i.e. they are not perfect substitutes for each other;
thus, the law of one price is not violated.
 However, the equally weighted portfolio outperforms Dreck’s share in any circumstances, so the
investor can benefit from this perfect dominance.
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 ARBITRAGE PORTFOLIO
 The investor opens a short position in Dreck’s share and its income is used to open a long position in
the equally weighted portfolio.
̵ So, short sell 300 thousand Dreck share and buy 100-100 thousand Apex, Bull and Crush shares, our profit
looks like the following:
High Interest Rate Low Interest Rate
Investment
Share
($) High Inflation Low Inflation High Inflation High Inflation

Apex (A) 1.000.000 -200.000 200.000 400.000 600.000

Bull (B) 1.000.000 0 700.000 300.000 -200.000
Crush (C) 1.000.000 900.000 -200.000 -100.000 700.000
Dreck (D) -3.000.000 -450.000 -690.000 -450.000 -1.080.000
Portfolio 0 250.000 10.000 150.000 20.000
̵ The value of our net investment is equal to zero; although the portfolio generates profit in any economic
condition.
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̵ The critical property of a risk-free arbitrage portfolio is that any investor, regardless of risk aversion or
wealth, will want to take an infinite position in it.
̵ Because those large positions will quickly force prices up and down until the opportunity vanishes,
̵ security prices should satisfy a “no-arbitrage condition,” that is, a condition that rules out the existence of
arbitrage opportunities.
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 NO ARBITRAGE
 There is an important difference between no-arbitrage and risk–return dominance
arguments in support of equilibrium price relationships.
 CAPM applies the risk–return dominance rule, which suggests that
̵ when equilibrium price relationship is violated, many investors will make limited portfolio
changes, depending on their degree of risk aversion.
̵ Aggregation of these limited portfolio changes is required to create a large volume of buying
and selling, which in turn restores equilibrium prices.
 By contrast, when arbitrage opportunities exist
̵ each investor wants to take as large a position as possible; hence
̵ it will not take many investors to create price pressures necessary to restore equilibrium.
 Therefore, implications for prices derived from no-arbitrage arguments are
stronger than implications derived from a risk–return dominance argument.
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 RISK-RETURN DOMINANCE VS. NO ARBITRAGE RULE
 CAPM
̵ Implying that all investors hold mean-variance efficient portfolios.
̵ If a security is mispriced, then investors will tilt their portfolios toward the underpriced
and away from the overpriced securities.
̵ Pressure on equilibrium prices results from many investors shifting their portfolios,
each by a relatively small dollar amount.
̵ The assumption that a large number of investors are mean-variance optimizers is
critical.
 APT
̵ In contrast, the implication of a no-arbitrage condition is that a few investors who
identify an arbitrage opportunity will mobilize large dollar amounts and quickly restore
equilibrium.
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 TERMINOLOGY - „ARBITRAGE ” AND „ARBITRAGEURS”
 Risk-free vs. risky
 Practitioners often use the terms arbitrage and arbitrageurs more
loosely than our strict definition.
̵ Arbitrageur often refers to a professional searching for mispriced
securities in specific areas such as merger-target stocks, rather than to
one who seeks strict (risk-free) arbitrage opportunities.
̵ Such activity is sometimes called risk-arbitrage to distinguish it from pure
arbitrage. 12

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 WELL-DIVERSIFIED PORTFOLIOS AND THE APT
 Stephen Ross developed the arbitrage pricing theory (APT) in 1976.
 Ross’s APT relies on three key propositions:
̵ (1) security returns can be described by a factor model;
̵ (2) there are sufficient securities to diversify away idiosyncratic risk; and
̵ (3) well-functioning security markets do not allow for the persistence of arbitrage opportunities.
 We begin with a simple version of Ross’s model, which
̵ assumes that only one systematic factor affects security returns.
 Thus, we begin with a single-factor model.
̵ Uncertainty in asset returns has two sources: a common or macroeconomic factor and firm-
specific events. 13

̵ The common factor is constructed to have zero expected value,

 because we use it to measure new information concerning the macroeconomy, which, by
definition, has zero expected value.
ELTE Faculty of Economics INTERNATIONAL FINANCIAL MANAGEMENT
 ONE FACTOR MODEL
̵ E(ri) is the expected excess return of firm i
𝑟 𝑖 =𝐸 ( 𝑟 𝑖 ) + 𝛽𝑖 𝐹 +𝑒 𝑖
̵ F is the deviation of the common factor from its expected value,
̵ bi is the sensitivity of firm i to that F factor,
̵ ei is the the firm-specific disturbance (noise).
̵ The nonsystematic components of returns, the ei’s, are assumed to be uncorrelated across
stocks and with the factor F.
 The factor model states that

̵ the actual excess return (ri) on firm i will equal to the sum of
 its initially expected value,
 a (zero expected value) random amount attributable to unanticipated economywide events,
 another (zero expected value) random amount attributable to firm-specific events.
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 CONSIDER AN EXAMPLE!
 Suppose that
̵ macro factor, F, is taken to be news about the state of the business cycle, measured by the
unexpected percentage change in gross domestic product (GDP), and that the consensus
is that GDP will increase by 4% this year.
̵ Suppose also that a stock’s b value is 1.2.
̵ If GDP increases by only 3%, then the value of F would be -1%,
 representing a 1% disappointment in actual growth versus expected growth.
 Given the stock’s beta value
̵ this disappointment would translate into a return on the stock that is 1.2% lower than
previously expected.
 This macro surprise, together with the firm-specific disturbance, ei, determines
the total departure of the stock’s return from its originally expected value.

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 WELL-DIVERSIFIED PORTFOLIOS’ RISK
 Consider the risk of a portfolio of stocks in a single-factor market. We first show
that if a portfolio is well diversified, its firm-specific or nonfactor risk becomes
negligible, so that only factor (or systematic) risk remains.
 The excess return on an n-stock portfolio with weights wi, Swi = 1, is

 We can divide the variance of this portfolio into systematic and nonsystematic
sources:

 Note that in deriving the nonsystematic variance of the portfolio, we depend on the
fact that the firm-specific eis are uncorrelated and hence that the variance of the
“portfolio” of nonsystematic eis is the weighted sum of the individual
nonsystematic variances with the square of the investment proportions as weights.
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 NONSYSTEMATIC RISK IS DISAPPEARING
 If the portfolio were equally weighted, w =1/n then the nonsystematic variance would
i
be:

̵ where the last term is the average value of nonsystematic variance across securities.
̵ Nonsystematic variance of the portfolio equals the average nonsystematic variance divided by n.
 Therefore, when n is large, nonsystematic variance tends to zero.
 This is the effect of diversification.
̵ Any portfolio for which each wi becomes consistently smaller as n gets large (more precisely, for
which each wi2 approaches zero as n increases) will satisfy the condition that the portfolio
nonsystematic risk will tend to zero.
 This property motivates us to define a well-diversified portfolio as one with each
weight, wi, small enough that for practical purposes the nonsystematic variance, s2(eP),
is negligible.
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 RETURN OF A WELL-DIVERSIFIED PORTFOLIO
 Because the expected value of ep for any well-diversified portfolio is zero,
and its variance also is effectively zero, we can conclude that any realized
value of ep will be virtually zero. Thus,

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 PORTFOLIOS IN PRACTICE
 However, well-diversified portfolios of institutional investors are generally not equally
weighted.
 The question is whether their portfolios can be considered as well diveresified
portfolios or not
̵ Consider a portfolio with 1000 different shares.
̵ Let the weight of the first share to be w in the portfolio.
̵ Let the weight of the second share to be 2w, the weight of the third’s to be 3w, and so on.
̵ This way the largest stake for weight will be (in the case of the thousandth share) 1000w.
 So, the question is: Can this portfolio be considered as a well diversified one,
taking that fact into account that the largest element is having one thousand
higher weight compared to the smallest?

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 THE ANSWER IS YEAH
 Let we determine the proportion of the share with the largest
weight!
 The sum of the weights is 100%, thus
𝑤+2𝑤+...+1000 𝑤=100 %
 Let we solve the eq. to w: w = 0,0002%, thus 1000w=0,2%.
 It suggests that the weight of the share with the largest weight
gives only two tenth of 1%.
 This portfolio is far from being an equally weighted one; however,
for practical purposes it can be considered as a well-diversified
portfolio.
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 BETAS AND EXPECTED RETURNS
 Only factor (or systematic) risk remains as the firm specific risk can be eliminated
by diversification.
̵ In equilibrium only the factor(systematic)-risk generates risk premium. The return of a not well-
diversified portfolio or a single stock is determined by other factors.
Excess return (%) Excess return (%)

A S

10 10

0 F 0 F

 If the macro-factor is positive, than the return of the well diversified portfolio
exceeds its expected value;𝐸 if
( 𝑟it𝐴 is
) + negative
𝛽 𝐴 𝐹 =10than
%+1it will
, 0 ×be
𝐹under the expected
value. Thus, the return will be
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