FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 19

B. Arbitrage Pricing Theory

An alternative model of equilibrium security pricing developed by Ross
(1976, Journal of Economic Theory Vol. 13: 341-360).
APT describes the expected return on an asset (or portfolio) as a linear
function of the risk of the asset (or portfolio) with respect to a set of
factors.
APT is more general than CAPM, with less restrictive assumptions. Yet,
like the CAPM it has limitations and is not the final word in asset
pricing. APT posits a relationship between expected return and risk
when the assets market is in equilibrium.
Each individual assets prices fluctuate because it is subject to both
idiosyncratic or firm-specific or nonsystematic risk and to systematic
risks. However, just like CAPM, APT predicts that a well-functioning
capital market rewards investors ONLY for bearing systematic risks.
This is because portfolios with many securities in them can diversify
away most of the idiosyncratic risk.
However, it is not critically dependent on an underlying market
portfolio as in the CAPM which predicts that only market risk
influences expected returns. Instead, APT recognizes that several types
of risks may systematically affect the returns on ALL securities.
For example, many stocks have been found to be affected not only by
overall market risk but also by surprises (unexpected) in interest
rates, inflation, and real economic growth. (Chen, Roll and Ross,
1986, Journal of Business, Vol. 59, No. 3:383-403)
APT is based on the LAW OF ONE PRICE: two identical assets cannot
sell at different prices. This implies that if two securities or portfolios
have the same risk, it must have the same expected return.
APT assumes that realized returns and expected returns are both
linearly related to a set of factors. Such factors represent broad
economic forces that affect all securities prices and therefore returns,
not firm-specific events or characteristics.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 20

Market participants develop expectations about the sensitivities of each

asset return to these factors. They buy and sell securities so that, given
the law of one price, securities affected equally by the same factors will
have equal expected returns. This buying and selling is the
ARBITRAGE PROCESS which determines the prices of securities.
APT predicts that in equilibrium, the market prices of securities will
adjust to eliminate any ARBITRAGE OPPORTUNITIES among welldiversified portfolios.
Arbitrage opportunities refer to situations where an investor can
construct a portfolio with ZERO INVESTMENT that will yield a
RISKLESS PROFIT. If arbitrage opportunities arise, APT argues that
a relatively few investors can act (buy or sell securities to take
advantage of the arbitrage profit) to restore equilibrium.
Assumptions of APT
Like CAPM, APT assumes:
1. investors have homogenous beliefs
2. investors are risk-averse expected utility maximizers
3. asset markets are perfectly competitive: there are an unlimited
number of assets, so investors can form well-divesified portfolios
that eliminate firm-specific or asset-specific risk
4. there are no restrictions on short selling of any of the assets
5. realized returns are generated by a factor model
Unlike CAPM, APT does not assume
1.
2.
3.
4.

a single period investment horizon

absence of taxes
borrowing and lending at the risk-free rate
investors selection of portfolios on the basis of expected return
and variances (Markowitz Model)

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 21

Deriving the APT

APT assumes that the realized return on any security j at any time t is
generated by a K-factor model. However, the model does not specify the
exact number of such factors. That is (ignoring the time subscript):

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

j = an error term with a zero mean that represents the portion of

the return to security j not explained by the factor model
(firm-specific surprise)

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

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 22

APT assumes

E "# i j $% = 0

Cov "# i , j $% = 0

Corr "# i , j $% = 0

for all i and j (i j)

nonsystematic risk of any portfolio P of N securities can be

N

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

In this formulation, it is assumed that Cov !" f s , f k #$ = 0 for all

factors s and k (s k) and for all t, although this is not a necessary
assumption of APT.
This is because even if there are nonzero covariance between
factors in P2 , such nonzero factor covariances will eventually
drop out for zero-beta (arbitrage) portfolios.
APT assumes

E "# j f k $% = 0

for all j and for all k.

Cov "# j , f k $% = 0

Corr "# j , f k $% = 0

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 23

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

5. Moreover, the variance of portfolio realized return is given by the

2
2
P2 = bP1
2f1 + bP2 2 2f2 +bPK
2f K + 2P

where

bPk = x j b jk
j=1

2f k Var ( f k ) and 2P = x 2j 2 j
j=1

Note that the portfolio factor k beta is simply bPk = x j b jk , where xj is

j=1

the weight of security j in portfolio P.

The above portfolio variance equation assumes that the covariance
between the factors is equal to zero. However, this is not a necessary
assumption for the APT.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 24

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

rit = ai + bi1 f1t + bi2 f2t + + biK f Kt + it

(1)

Taking the expectation of (1), we get

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)

rit = E rit + bi1 f1t + bi2 f2t + + biK f Kt + it

(3)

Recall that APT assumes that Corr " it , jt # = 0 Corr " it , f kt # = 0 .

$
%
$&
%'
Now, an arbitrage or zero-beta portfolio must satisfy two conditions [(4)
and (5)]

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 25

N

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

rPt = X i E rit + bi1 f1t ++ biK f Kt + it

i=1
N

X i E rit + X ibi1 f1t

i=1

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)

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 26

N

risk diversifies to zero ( 2P = X i2 2i 0 , since as N then Xi and

j =1

X i2

0 ), then (6) can be written as

N

rPt = X i E !# rit "$ = E !# rPt "$

i =1

( 7)

where the second equality holds by definition of portfolio expected

return.
Since the arbitrage portfolio has an actual return rPt equal to expected
return E !# rPt "$ , then there is zero variability in its return and is
therefore riskless!
That is,

E !# rPt "$ =

X i E !# rit "$ > 0

i =1

( 8)

Now, given the (orthogonality) conditions

E "$ it f kt #% = 0 ,
N

X i bik = 0 ,
i =1

Xi = 0,

i =1

E !# rPt "$ = X i E !# rit "$ > 0

i =1

then, it can be shown that the expected return on any well-diversified

portfolio may be written as a linear combination of the factor betas, i.e.,

E rPt = 0 +1bP1 ++ K bPK

where

E !# rPt "$ aP = expected return on portfolio P

0 = expected return on a zero-beta portfolio (risky portfolio with
zero sensitivity to all factors) or the risk-free rate, rf, if a riskfree asset exists

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 27

k = the risk premium for factor k = fk 0, for k = 1, . . . , K are

the same for all portfolios
bPk = the sensitivity of the return on a well-diversified portfolio P
to factor k
For individual securities which are clearly not well-diversified, APT
prediction on its expected return is an approximation

E rit 0 +1bi1 ++ K biK

where
ai = i = expected return on individual security i or a
portfolio i with idiosyncratic risk
bik = the sensitivity of the individual asset or portfolio i with
idiosyncratic risk to factor k
Only an approximation since the general relationship may not hold
exactly (i.e., there will be deviations) due to the presence of firm-specific
risk.
The APT Equilibrium Expected Return - Risk Relationship Summarized
In equilibrium, when there are no more opportunities for pure, riskless
arbitrage profits, the expected return to any well-diversified portfolio P
is linearly related to the factor sensitivities of that portfolio. The factor
sensitivities represents portfolio Ps exposure to the systematic risks.
That is, in equilibrium

aP = 0 + 1bP1 + 2bP 2 + + K bPK

The APT equation can describe (at least approximately) the expected
return on an individual asset or portfolio j with asset-specific risk
(idiosyncratic risk or nonsystematic risk), under certain conditions.

a j 0 + 1b j1 + 2b j2 + + K b jK

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 28

This is written as an approximation because while the general

relationship between the factor risks and expected return will be linear,
there may still be individual deviations from the relationship (due to
presence of firm-specific risk because the portfolio is not welldiversified) so long as there isnt a sufficient number of them to open up
riskless arbitrage opportunities.
Interpreting the Factor Risk Premiums, k for k = 1, 2, , K
Assume a two-factor Exact APT

E !" rP #$ = 0 + 1bP1 + 2bP 2 ,

where E !" rP #$ aP

Consider a well-diversified zero-beta portfolio Z, i.e., bP1 = bP 2 = 0

which has expected return E ! rZ " .
# $

E !" rZ #$ = 0 + 1 ( 0) + 2 ( 0) = 0

Then,

0 = E "$ rZ #% .

If riskless borrowing and lending exist, then

E !# rZ "$ = r f

0 = r f .

Next, consider a well-diversified portfolio P with bP1 = 1 and bP 2 = 0

with expected return E rP .
1
Since this portfolio mimics the unexpected movements in factor 1 (a.k.a.
factor 1 portfolio), then

E "$ rP #% = f1 = 0 +1 (1) + 2 ( 0 ) = 0 +1
&

'

1 = f1 0
1 = f1 E "$rZ #% .

If riskless borrowing and lending exist then

1 = f1 r f

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 29

Next, consider a well-diversified portfolio P with bP1 = 0 and bP 2 = 1

with expected return E !# rP $& .
" 2%
Since this portfolio mimics the unexpected movements in factor 2 (a.k.a.
factor 2 portfolio), then

E !#" rP

$
= f1 = 0 + 1 ( 0) + 2 (1) = 0 + 2
%
2&
2 = f 2 E #$ rZ %&

2 = f 2 0

or 2 = f 2 r f if riskless borrowing and lending exist.

Thus, k represents the expected return on a portfolio whose beta with
respect to factor k is 1 and 0 for all other factors.
Hence, at equilibrium, the two-factor APT predicts that for welldiversified portfolios,

E !" rP #$ = E !" rZ #$+ !" f1 E !" rZ #$#$bP1 + !" f 2 E !" rZ #$#$bP 2

or

E !" rP #$ = r f + !" f1 r f #$bP1 ++ !" f K r f #$bPK if riskless borrowing and

lending exist.
To generalize for K factors, the K-factor APT predicts that for welldiversified portfolios

E !" rP #$ = E !" rZ #$+ !" f1 E !" rZ #$#$bP1 ++ !" f K E !" rZ #$#$bPK

or

E !" rP #$ = r f + !" f1 r f #$bP1 ++ !" f K r f #$bPK if riskless borrowing and

lending exist.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 30

Summary: APT can be summarized in two equations

Exact APT: for well-diversified portfolios
(1) rP = aP + bP1 f1 + bP 2 f2 ++ bPK f K + P

and

(2) E !" rP #$ = 0 + 1bP1 + 2bP 2 ++ K bPK , where E !" rP #$ = aP

Approximate APT: for individual securities and portfolios with
firm-specific risk
(1) ri = ai + bi1 f1 + bi2 f2 ++ biK f K + i

and

(2) E !" ri #$ 0 + 1bi1 + 2bi2 ++ K biK , where E !# rit "$ = ai

Consider the following case.
Assume a single factor can explain all the covariances that exist between
all securities returns. What will the relationship between the expected
return to securities and their responsiveness to the single factor, b1P,
look like?
If the relationship is nonlinear, it can be shown than such nonlinear
relationship is infeasible, given the APT assumptions. This is because, if
it is nonlinear, any one investor could make unlimited sums of money
with no required investment and no assumed risk.
Assume an unlimited number of securities. Four of these securities are
labeled at points B, C, E, and F.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 31

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.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 32

Also, we have assumed the position at E[rZ] by using two securities C

and E, but we could have also assumed the position E[rZ] by using four
securities: short selling stocks E and F and using the proceeds to invest
in securities C and B.
Furthermore, we can assume a portfolio position E[rZ] by using many
pairs of stocks as we want. Since there is an infinite number of
securities, by assumption, scattered along the nonlinear curve, we can
use an infinite number of pairs to assume the position E[rZ]. If we do
this, not only will this portfolio be well-diversified. It will also have a
zero portfolio variance.
The previous result is because the portfolio position E[rZ] has zero beta
by construction, then its systematic risk is zero. Its residual variance is
N

also zero on the basis of the equation 2P = xi2 2i . Since the number
i =1

of securities, N, is equal to infinity, the individual portfolio weights, Xjs,

are so small that when we square them, in taking the weighted average,
2

the residual variance sums to approximately zero: P = xi2 2i 0 .

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

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 33

relationship between expected return and factor risk, then pure, riskless
arbitrage opportunities are unavailable.

aj
F
E
C
B

1
E !# rZ% "$

b j1

Therefore, it is only when there is a linear relationship between the

expected return and risk that riskless arbitrage opportunities no longer
exist and which satisfies the APT condition.
Thus, in a single-factor APT, the factor risk-expected return
relationship of any security or portfolio i is given by
a j = 0 + 1b j1
a j = E rZ + 1b j1
or
where

aj = j = expected return on security or portfolio j

0 = E[rZ] = expected return on a zero-beta portfolio or
riskless rate of return rf is a risk-free asset exists

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 34

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

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 35

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.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 36

Example 1: One-Factor APT

Assume a one-factor APT. Further assume that all portfolios are welldiversified and all firm-unique risk is zero (i.e., 2 = 0 for all P). The
P

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

a. Plot the three securities in the expected return beta space.

b. Based on the graph, can you tell if a riskless arbitrage opportunity
exists? Why?
c. If such an arbitrage opportunity exists, design an arbitrage portfolio
using the three portfolios.
d. If a number of investors discover the same arbitrage opportunity and
designs an arbitrage portfolio like yours, explain what would eventually
happen to the three portfolios expected returns in equilibrium?
Explain.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 37

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.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 38

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:

bD1 = ( 0.5*bA1 ) + ( 0.5*bC1 ) = ( 0.5* 0.5) + ( 0.5*1.5) =1.0 = bB1

However, the expected return of this portfolio D is

D = ( 0.5* A ) + ( 0.5* C ) = ( 0.5*7.5% ) + ( 0.5*12.5% ) =10% < B =12%

Now, according to the Law of One Price, two assets with identical risk
must sell at identical prices (and therefore, have identical returns).
It is the extra 2% constant return that will provide the arbitrage profit.
For the arbitrage portfolio, we want the factor risk of the portfolio D to
exactly offset the 1.0 factor risk of B so that the net factor sensitivity of
this portfolio is zero (zero risk) and we obtain the extra return of 2%
without any cash investment on our part (zero investment).
To do these, we create the arbitrage portfolio that consists of:
BUY 1 of portfolio B:

earn 12.0%

risk is 1.0

SHORT SELL 1 of Portfoio D (a portfolio that invests 50% in A and

50% in C):
give up 10.0%

risk (given up) is 1.0

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 39

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 Risk End-of-Period Cash Inflow

bi1
+ 1.0
+ 1.12
[= 1*(1+0.12)]
1.0
1.1
[= 1*(1+0.11) ]
0.25
0.5375
[= 0.5*0.5]
[= 0.5*(1.075)]
0.75
0.5625
[= 0.5*1.5]
[= 0.5*(1.175)]
0.0
0.02

The arbitrage portfolio earns a riskless profit of 0.02 per 1 purchased

of B financed by the 1 proceeds of selling short a portfolio D
(consisting of 50% A and 50% C), which represents the 2% greater
expected return available on portfolio B.
d. Of course, anyone seeing the situation in part 1 would jump at such
an arbitrage. Consequently, as a result of many such trades or arbitrage
transactions, the prices of the securities would adjust until the
relationship between each securitys expected returns and its sensitivity
to the factor is linear.
How?
After all arbitrage trades, the supply of A and C would have increased
(as individuals sell these portfolios). The prices of A and C decrease and
consequently the expected returns on A and C increase.
Simultaneously, the demand for B would have increased (as individuals
buy this portfolio). The price of B increases and the expected return on
B decreases.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 40

The prices of A, B, and C (and therefore expected returns) cease to

change when there are no more arbitrage opportunities possible, which
is the case when the expected return on the portfolio containing A and C
which has factor risk of 1.0 is just equal to the expected return on
portfolio B which has the same factor risk of 1.0.
Therefore, in equilibrium, when there are no more arbitrage profits
possible, portfolios A, B, and C will lie along a line in the expected
return factor 1 sensitivity space.
Example 2:
Assume a two-factor APT and consider the following portfolios:
Portfolio, P
A
B
C

Expected Return (%)

15
14
10

Factor 1 beta
1.0
0.5
0.3

Factor 2 beta
0.6
1.0
0.2

a. Assume that the three portfolios are well-diversified and are

correctly priced according to the two-factor APT. What are the
equilibrium values of the risk-free rate, factor 1 risk premium,
and factor 2 risk premium?
Since each portfolio is well-diversified and correctly priced according to
the two-factor APT, then each of these portfolios satisfies the exact APT
prediction that aP = 0 + 1bP1 + 2bP 2 , where aP P , 0 = risk-free
rate, 1 = factor 1 risk premium and 2 = factor 2 risk premium.
From the given table, we have that
Portfolio, P
A
B
C

aP (%)
15
14
10

bP1
1.0
0.5
0.3

bP2
0.6
1.0
0.2

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 41

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:

0 = 7.75% = risk-free rate

1 = 5% = factor 1 risk premium
2 = 3.75% = factor 2 risk premium
b. Using the above information, find the equation of the plane that
must describe equilibrium expected returns on any welldiversified portfolio j based on the two-factor APT.
The general equation for the plane describing the equilibrium expected
returns on any portfolio j according to a two-factor APT is

aP = 0 + 1bP1 + 2bP 2 , where aP P

Given the results in part a, we have that

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

Since the portfolio P factor k beta is simply bPk = x j b jk

j =1

where xj is the weight of asset j in portfolio P,

Since xA = , xB = , xC = , the factor betas of portfolio P are
1
4

1
4

1
2

for k = 1, bP1 = (1 ) + ( 0.5 ) + ( 0.3 ) = 0.525

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 42

1
4

1
4

1
2

and for k = 2, bP2 = ( 0.6 ) + (1 ) + ( 0.2 ) = 0.5

According to the two-factor APT, the equilibrium expected return on
any portfolio should lie along the hyperplane with equation
a j = 7.75 + 5b j1 + 3.75b j2 . Thus, the expected return on portfolio P is

aP = 7.75 + 5 ( 0.525) + 3.75 ( 0.5) = 12.25 or 12.25%

d. Suppose that a portfolio called E with the following properties
were observed: Expected return on E = 15%, bD1 = 0.6, bD2 = 0.6.
Is there an arbitrage opportunity? Why or why not?
If portfolio E is correctly priced according to the two-factor APT, then
portfolio E must lie along the plane described in part b and its expected
return must satisfy aP = 7.75 + 5bP1 + 3.75bP 2 .
That is, aE = 7.75 + 5 ( 0.6) + 3.75 ( 0.6) = 13 or 13%
Since the observed aE = 15% > 13% = true aE , portfolio E lies above the
plane described in part b and an arbitrage opportunity exists. In this
case, portfolio is underpriced.
Example 3: Two-Factor APT and the Arbitrage Portfolio
Consider Example 2 in which the general equation for the plane
describing the equilibrium expected returns on any portfolio j according
to a two-factor APT was found to be a j = 7.75 + 5b j1 + 3.75b j2 and
for which portfolio E with the observed properties
expected return = 15%, bD1 = 0.6, bD2 = 0.6, Since the observed
aE = 15% > 13% = true aE , portfolio E lies above the plane and an
arbitrage opportunity exists. In this case, portfolio is underpriced.
Design an arbitrage portfolio using the four portfolios (A, B, C, E).

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 43

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
%

The risk for portfolio D is identical to the risk on portfolio E. However,

the expected return on portfolio D is
!1
$ !1
$ !1
$
D = ( 0.5* A ) + ( 0.5* C ) = # *15% & + # *14% & + # *10% & =13% < E =15%
"3
% "3
% "3
%
Alternatively, since portfolio D lies on the plane, its equilibrium
expected return is given by

aD = 7.75 + 5bD1 + 3.75bD2 = 7.75 + 5 ( 0.6) + 3.75 ( 0.6) = 13%

Now, by the law of one price, two portfolios that have the same risk
cannot sell at a different expected return. In this situation, it would pay
arbitrageurs to step in and buy portfolio E and financing while selling
an equal amount of portfolio D short.
Buying portfolio E and financing it by selling D short would guarantee a
riskless profit with no investment and no risk. To illustrate, assume the
investor sells 1 worth of portfolio D short and buys 1 worth of
portfolio E. The results are show in the following table.

FINNLEC Lecture Notes Section 6 - Equilibrium Asset Pricing Theories Part 2 44

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

The arbitrage portfolio earns a riskless profit of 0.02 per 1 purchased

of E financed by the 1 proceeds of selling short a portfolio D
(consisting of 1/3 of A, 1/3 of B, and 1/3 of C). Arbitrage would continue
until portfolio E lies on the same plane as portfolios A, B, and C.