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r j = a j + b j1 f1 + b j2 f2 + + b jK f K + j
where
rj = realized return on security j
aj = j = expected return on security j
fk = the surprise in factor k or the unexpected or unanticipated
portion of factor k, k = 1, . . . , K
bjk = the sensitivity of the return on security j to a
surprise in factor k; a.ka. security js factor k beta or factor
k sensitivity
Var ( j ) = 2j
E "# j $% = 0
E !" f k #$ = 0 for all k and for all t
For portfolios, rPt = aP + bP1 f1t + bP 2 f2t + + bPK f Kt + Pt
where aP and the bPks are simple weighted averages of individual
assets ai s and biks:
N
P = x j j
i=1
#N
&
bPk = % x jb jk (
%
$ j=1
(
'
for
k = 1,, K
P = x j j
j=1
APT assumes
E "# i j $% = 0
Cov "# i , j $% = 0
Corr "# i , j $% = 0
written as 2 = x 2j 2
P
j=1
2
2
portfolio variance (total risk) is P2 = bP1
2f ++ bPK
2f + 2
1
where
bPk = x j b jk
i=1
2
fk
Var ( f k )
and 2P = x 2j 2j
j=1
E "# j f k $% = 0
Cov "# j , f k $% = 0
Corr "# j , f k $% = 0
Notes:
1. Consider security js actual return
rit = ai + bi1 f1t + bi2 f2t + + biK f Kt + it
Taking its expectation, we get E !" r j #$ = a j
since APT assumes E "# j $% = 0 and E !" f k #$ = 0 for all k.
Similarly, for any portfolio P, it can be shown that E !" rP #$ = aP .
2. The individual factor betas can be positive or negative from factor
to factor and from security to security.
3. It is assumed that all covariances between the rates of return to
the securities are attributable to the effect of the factors, and thus
the residual term will be uncorrelated between individual assets;
i.e., Corr( i, j) = 0 for all i and j (i j)and for all t.
4. Consequently, the residual variance (nonsystematic or
idiosyncratic variance) for any portfolio of individual securities,
P, is the weighted sum of the individual securities residual
N
variances; i.e., 2P = x 2j 2 j .
j=1
where
bPk = x j b jk
j=1
2f k Var ( f k ) and 2P = x 2j 2 j
j=1
Even with nonzero covariances between the factors, with the portfolio
variance equation having some additional terms relating to factor
covariances, when the assets market is in equilibrium these factor
covariance terms will all drop out for ZERO BETA portfolios (riskless
arbitrage portfolios), leaving the variance of the portfolios equal to the
residual variance.
6. The above model is known as a factor model of returns, but it
does not say anything about equilibrium. If we transform the
above equation into an equilibrium model, then we are saying
something about expected returns across securities.
Need to transform above K-factor model of returns into an equilibrium
model. How will the APT equilibrium expected return - risk
relationship look like?
Consider asset is actual return
(1)
E !#rit "$ = ai
(2)
since APT assumes E " it # = 0 for all t and E ! f kt " = 0 for all k and for
$ %
#
$
all t.
Subsitute (2) in (1)
(3)
bPk = X i bik = 0
Zero risk:
(4)
i =1
(zero-beta)
for all k = 1, . . . , K.
N
Xi = 0
i =1
Zero investment:
(5)
(self-financing portfolio)
Since in the arbitrage portfolio, some securities will be sold short
( X i < 0 for some i) and proceeds used to buy other securities ( X i > 0
for other i)
Arbitrage condition:
If investors have zero investment in the zero beta portfolio and
earns a positive (nonzero) expected return, then a risk-free profit
can be earned by arbitrage.
This arbitrage condition implies that
N
rPt = X i rit
i=1
N
i=1
rPt =
++ X ibiK f Kt
i=1
using ( 3 )
N
+ X i it
i=1
Model (6) is for actual portfolio return and does not yet say anything
when the capital market is in equilibrium.
APT has predictions on expected return on well-diversified portfolios
and on expected return on individual assets (clearly not welldiversified).
Create the arbitrage portfolio using (4) and (5) in (6) and the
assumption that for a large well-diversified portfolio, the nonsystematic
( 6)
X i2
( 7)
E !# rPt "$ =
i =1
( 8)
E "$ it f kt #% = 0 ,
N
X i bik = 0 ,
i =1
Xi = 0,
i =1
a j 0 + 1b j1 + 2b j2 + + K b jK
where E !" rP #$ aP
E !" rZ #$ = 0 + 1 ( 0) + 2 ( 0) = 0
Then,
0 = E "$ rZ #% .
E !# rZ "$ = r f
0 = r f .
E "$ rP #% = f1 = 0 +1 (1) + 2 ( 0 ) = 0 +1
&
'
1 = f1 0
1 = f1 E "$rZ #% .
1 = f1 r f
E !#" rP
$
= f1 = 0 + 1 ( 0) + 2 (1) = 0 + 2
%
2&
2 = f 2 E #$ rZ %&
2 = f 2 0
and
and
j
E
F
C
B
E !# rZ% "$
b j1
Since both beta and portfolio expected return are simple weighted
averages of the betas and the expected returns of the individual
securities we put into the portfolio, combination lines of individual
securities can be drawn as straight lines through the points on the
graph.
For example, the combination line for securities C and E is given by the
line passing through points E[rZ], C, and E. Positions between C and E
are taken by investing positive amounts of money in both stocks.
Positions between E[rZ] and C are taken by short selling security E and
using the proceeds to invest in security C.
Note that by short selling security E and investing in C, we can
construct a portfolio positioned on the graph at point E[rZ]. The beta of
this portfolio is equal to zero.
also zero on the basis of the equation 2P = xi2 2i . Since the number
i =1
Thus the portfolio position E[rZ] has no systematic risk and almost no
residual variance, but it has an expected (riskless) rate of return equal
to E[rZ].
Note that as long as the expected return-risk relationship is nonlinear,
we can always construct zero-variance, or riskless, portfolios that do not
require an investment on our part. These are known as riskless
arbitrage portfolios or opportunities.
However, in our attempts to make arbitrage profits, our short selling
activity will drive down the prices of the securities we are short selling
(such as E and F) and drive up their expected rates of return. Similarly,
our buying activity will drive up the prices of the securities we buy (such
as (C and B) and drive down their expected returns.
The effect of all of these will be to unbend the nonlinear curve until
the general relationship between the expected return and the factor
sensitivity or risk becomes approximately LINEAR. Given this linear
relationship between expected return and factor risk, then pure, riskless
arbitrage opportunities are unavailable.
aj
F
E
C
B
1
E !# rZ% "$
b j1
Two-Factor APT
Assume that the actual return on any portfolio j at any time t is
generated by a two-factor model and is given by the equation
r j = a j + b j1 f1 + b j2 f2 + j . Assume that all firm-specific risk is zero.
Then according to APT, in equilibrium a j = 0 + 1b j1 + 2b j2 for all
well-diversifies portfolios; that is, the expected return on portfolio j, aj,
should exactly be linearly related to the two factor sensitivities, bj1 and
bj2.
In this case, the expected returns are related to the two factor
sensitivities by a hyperplane in the expected return bj1 bj2 space,
otherwise an arbitrage opportunity exists.
Graphically,
b j2
aj
b j1
If this were not the case, then an arbitrage opportunity will exist. If a
few investors discover such opportunity and construct an arbitrage
portfolio with zero risk and zero investment, the arbitrage activities will
continue until no more arbitrage opportunities exist and the security lies
on the hyperplane.
For this two-factor APT, if expected returns on either factor are not
linearly related to the factor sensitivities, then an arbitrage is possible.
If there are two factors, any arbitrage must result in zero factor
sensitivities to both factor 1 and factor 2. This can be done by selecting
proper percentage holdings of the various portfolios available.
Specifically, if the observed expected return for a portfolio lies above
the plane (when the observed expected return is greater than the true
expected return), then such portfolio is underpriced. An arbitrage
portfolio with zero risk and positive expected return can be constructed
involving buying the underpriced portfolio financed by short-selling a
portfolio of correctly-priced portfolios with the same risk (factor
sensitivies bj1 and bj2) as the underpriced portfolio. As investors
recognize this mispricing and buy the underpriced portfolio, its price
should eventually go up and its expected return will go down to the true
expected return when there are no more arbitrage opportunities
available in the capital market.
Conversely, if the observed expected return for a portfolio lies below the
plane (when the observed expected return is lower than the true
expected return), then such portfolio is overpriced. An arbitrage
portfolio with zero risk and positive expected return can be constructed
involving short-selling the overpriced portfolio to finance the purchase
of a portfolio of correctly-priced portfolios with the same risk (factor
sensitivies bj1 and bj2) as the overpriced portfolio. As investors recognize
this mispricing and short-sell the overpriced portfolio, its price should
eventually go down and its expected return will go up to the true
expected return when there are no more arbitrage opportunities
available in the capital market.
expected return and the beta with respect to the single factor for three
portfolios are given as follows
Portfolio, P
A
B
C
7.5%
12%
12.5%
bP1
0.5
1.0
1.5
Answers:
a. A plot of the portfolios on the expected return factor sensitivity
space is as follows:
aP
bP1
b. Clearly, the portfolios expected returns are not linearly related to
their factor sensitivities. Therefore, an arbitrage opportunity that is
riskless (zero factor sensitivity) and requires zero investment exists
c. An arbitrage consists of a transaction that guarantees a risk-free
profit with no capital commitment (zero investment). For Example 1,
such arbitrage portfolio consists of the following transactions. Buy
portfolio B and finance the purchase by short selling a portfolio of A
and C such that its factor sensitivity is identical to that of B.
Why?
Portfolio B has a factor sensitivity of 1.0 and expected return of 12%.
If we were to invest 50% in A and 50% in C, we can form a portfolio
(call it D) with a portfolio factor sensitivity that is exactly the same as
that of B:
earn 12.0%
risk is 1.0
Arbitrage Portfolio
Buy 1 of B
(Short) Sell 1 D
(xA = 0.5, xC = 0.5)
A
C
Initial Cash
Outflow
1
+ 1
+ 0.5
[ = 0.5*1]
+ 0.5
[ = 0.5*1]
0.0
Factor 1 beta
1.0
0.5
0.3
Factor 2 beta
0.6
1.0
0.2
aP (%)
15
14
10
bP1
1.0
0.5
0.3
bP2
0.6
1.0
0.2
Thus,
For portfolio A, 15% = 0 + 1 + 0.62
For portfolio B, 14% = 0 + 0.51 + 2
For portfolio C, 10% = 0 + 0.31 + 0.22
These three equations can be solved for the unknowns, 0, 1, and 2:
a j = 7.75 + 5b j1 + 3.75b j2
c. According to the two-factor APT, what would be the expected
return on a portfolio P that invests one-quarter in A, one-quarter
in B, and one-half in C?
N
1
4
1
2
1
4
1
2
Answer:
Since a weighted combination of points on a plane (where the weights
sum to one) also lies on the plane, all portfolios constructed from
portfolios A, B, and C lie on the plane a j = 7.75 + 5b j1 + 3.75b j2 described
by these portfolios.
Compare portfolio E with a portfolio (call it D) constructed to lie on the
plane by placing 1/3 of the funds in portfolio A, 1/3 in portfolio B, and
1/3 in portfolio C. The factor sensitivities for portfolio D are
!1
$ !1
$ !1
$ !1
$ !1
$ !1
$
bD1 = # *bA1 & + # *bB1 & + # *bC1 & = # *1.0 & + # * 0.5 & + # * 0.3 & = 0.6 = bE1
"3
% "3
% "3
% "3
% "3
% "3
%
!1
$ !1
$ !1
$ !1
$ !1
$ !1
$
bD2 = # *bA2 & + # *bB2 & + # *bC 2 & = # * 0.6 & + # *1.0 & + # * 0.2 & = 0.6 = bE2
"3
% "3
% "3
% "3
% "3
% "3
%
Arbitrage Portfolio
Initial Cash
Outflow
Buy 1 of E
Factor 1
Risk
bi1
+ 0.6
Factor 2
Risk
bi2
+ 0.6
(Short) Sell 1 of D
(xA = 1/3,
xB = 1/3,
xC = 1/3)
+ 1
0.6
0.6
+ 1/3
[= 1/3*1]
+ 1/3
[= 1/3*1]
+ 1/3
[= 1/3*1]
0.0
1/3
[= 1/3*1.0]
1/5
[= 1/3*0.6]
1/6
[= 1/3*0.5]
1/3
[= 1/3*1.0]
1/10
[= 1/3*0.3]
0.0
1/15
[= 1/3*0.2]
0.0
End-of-Period Cash
Inflow
+ 1.15
[=1.0*(1+0.15)]
1.13
[=1.0*(1+0.13)]
0.38333333
[= 1/3*(1.15)]
0.38
[= 1/3*(1.14)]
0.06666667
[= 1/3*(1.1)]
0.02