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MBA Semester 3
Sign :
Q. 1
Ans:
Technicians using charts search for archetypal price chart patterns, such
as the well-known head and shoulders or double top/bottom reversal
patterns, study indicators, moving averages, and look for forms such as
lines of support, resistance, channels, and more obscure formations such
as flags, pennants, balance days and cup and handle patterns.
Technical analysts also widely use market indicators of many sorts, some
of which are mathematical transformations of price, often including up anf
down volume, advance/decline data and other inputs. These indicators are
used to help access whether an asset is trending, and if it is, its probability
of its direction and of continuation. Technicians also look for relationships
between price/volume indices and market indicators. Examples include the
relative strength index, and MACD. Other avenues of study include
correlations between changes in options (implied volatility) and put/call
ratios with price. Also important are sentiment indicators such as Put/Call
ratios, bull/bear ratios, short interest and Implied Volatility, etc.
Principles
Technical analysts believe that prices trend directionally, i.e., up, down, or
sideways (flat) or some combination. The basic definition of a price trend
was originally put forward by Dow Theory.
Note that the sequence of lower lows and lower highs did not begin until
August. Then AOL makes a low price that doesn't pierce the relative low
set earlier in the month. Later in the same month, the stock makes a
relative high equal to the most recent relative high. In this a technician
sees strong indications that the down trend is at least pausing and possibly
ending, and would likely stop actively selling the stock at that point.
Q.2
Explain role played by efficient market in economy. Apply the
parameters of efficient market to Indian stock markets and find
out whether they are efficient.
Ans:
The validity of the hypothesis has been questioned by critics who blame
the belief in rational markets for much of the financial crisis of 2007–2010.
Defenders of the EMH caution that conflating market stability with the EMH
is unwarranted; when publicly available information is unstable, the
market can be just as unstable.
The (now largely discredited) theory that all market participants receive
and act on all of the relevant information as soon as it becomes available.
If this were strictly true, no investment strategy would be better than a
coin toss. Proponents of the efficient market theory believe that there is
perfect information in the stock market. This means that whatever
information is available about a stock to one investor is available to all
investors (except, of course, insider information, but insider trading is
illegal). Since everyone has the same information about a stock, the price
of a stock should reflect the knowledge and expectations of all investors.
The bottom line is that an investor should not be able to beat the market
since there is no way for him/her to know something about a stock that
isn't already reflected in the stock's price. Proponents of this theory do not
try to pick stocks that are going to be winners; instead, they simply try to
match the market's performance. However, there is ample evidence to
dispute the basic claims of this theory, and most investors don't believe it.
The efficient market hypothesis is related to the random walk theory. The
idea that asset prices may follow a random walk pattern was introduced by
Bachelier in 1900. The random walk hypothesis is used to explain the
successive price changes which are independent of each other. Fama
(1991) classifies market efficiency into three forms - weak, semi-strong
and strong. In its weak form efficiency, equity returns are not serially
correlated and have a constant mean. If market is weak form efficient,
current prices fully reflect all information contained in the historical prices
of the asset and a trading rule based on the past prices can not be
developed to identify miss-priced assets. Market is semi-strong efficient if
stock prices reflect any new publicly available information instantaneously.
There are no undervalued or overvalued securities and thus, trading rules
are incapable of producing superior returns. When new information is
released, it is fully incorporated into the price rather speedily. The strong
form efficiency suggests that security prices reflect all available
information, even private information. Insiders profit from trading on
information not already incorporated into prices. Hence the strong form
does not hold in a world with an uneven playing field. Studies testing
market efficiency in emerging markets are few. Poshakwale (1996) showed
that Indian stock market was weak form inefficient; he used daily BSE
index data for the period 1987 to 1994. Barua (1987), Chan, Gup and Pan
(1997) observed that the major Asian markets were weak form inefficient.
Similar results were found by Dickinson and Muragu (1994) for Nairobi
stock market; Cheung et al (1993) for Korea and Taiwan; and Ho and
Cheung (1994) for Asian markets. On the other hand, Barnes (1986)
showed a high degree of efficiency in Kuala Lumpur market. Groenewold
and Kang (1993) found Australian market semi-strong form efficient. Some
of the recent studies, testing the random walk hypothesis (in effect testing
for weak form efficiency in the markets) are; Korea (Ryoo and Smith, 2002;
this study uses a variance ratio test and find the market to follow a random
walk process if the price limits are relaxed during the period March 1988 to
Dec 1988), China, (lee et al 2001; find that volatility is highly persistent
and is predictable, authors use GARCH and EGARCH models in this study),
Hong Kong (Cheung and Coutts 2001; authors use a variance ratio test in
this study and find that Hang Seng index on the Hong Kong stock
exchange follow a random walk), Slovenia (Dezlan, 2000), Spain (Regulez
and Zarraga, 2002), Czech Republic (Hajek, 2002), Turkey (Buguk and
Brorsen, 2003), Africa (Smith et al. 2002; Appiah-kusi and Menyah, 2003)
and the Middle East (Abraham et al. 2002; this study uses variance ratio
test and the runs test to test for random walk for the period 1992 to 1998
and find that these markets are not efficient).
Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and MacKinlay
1988) are used to test the weak form efficiency and random walk
hypothesis. Runs test determines if successive price changes are
independent. It is non-parametric and does not require the returns to be
normally distributed. The test observes the sequence of successive price
changes with the same sign. The null hypothesis of randomness is
determined by the same sign in price changes. The runs test only looks at
the number of positive or negative changes and ignores the amount of
change from mean. This is one of the major weaknesses of the test.
LOMAC variance ratio test is commonly criticised on many issues and
mainly on the selection of maximum order of serial correlation (Faust,
1992). Durbin-Watson test (Durbin and Watson 1951), the augmented
Dickey-Fuller test (Dickey and Fuller 1979) and different variants of these
are the most commonly used tests for the random walk hypothesis in
recent years (Worthington and Higgs 2003; Kleiman, Payne and Sahu
2002; Chan, Gup and Pan 1997). Under the random walk hypothesis, a
market is (weak form) efficient if most recent price has all available
information and thus, the best forecaster of future price is the most recent
price. In the most stringent version of the efficient market hypothesis, εt is
random and stationary and also exhibits no autocorrelation, as disturbance
term cannot possess any systematic forecast errors. In this study we have
used returns and not prices for test of market efficiency as expected
returns are more commonly used in asset pricing literature (Fama (1998).
Returns in a market conforming to random walk are serially uncorrelated,
corresponding to a random walk hypothesis with dependant but
uncorrelated increments. Parametric serial correlations tests of
independence and non-parametric runs tests can be used to test for serial
dependence. Serial correlation coefficient test is a widely used procedure
that tests the relationship between returns in the current period with those
in the previous period. If no significant autocorrelation are found then the
series are expected to follow a random walk. A simple formal statistical
test was introduced was Durbin and Watson (1951). Durbin-Watson (DW) is
a test for first order autocorrelation. It only tests for the relationship
between an error and its immediately preceding value. One way to
motivate this test is to regress the error of time t with its previous value.
Where: St = the stock price u* and u** = the drift terms T = total number
of observations εt, εt*, εt** = error terms that could be ARMA processes
with time dependent variances.
In this study we calculate daily returns using daily index values for the
Mumbai Stock Exchange (BSE) and National Stock Exchange (NSE) of India.
The data is collected from the Datastream data terminal from Macquarie
University. The time period for BSE is from 24th May 1991 to 26th May
2006 and for NSE 27th May to 26th May 2006. Stock exchanges are closed
for trading on weekends and this may appear to be in contradiction with
the basic time series requirement that observations be taken at a regularly
spaced intervals. The requirement however, is that the frequency be
spaced in terms of the processes underlying the series. The underlying
process of the series in this case is trading of stocks and generation of
stock exchange index based on the stock trading, as such for this study
the index values at the end of each business day is appropriate (French
1980). Table 1 presents the characteristics of two data sets used in this
study. During the period covered in this study, the mean return of the NSE
index is much lower than that of the BSE, similarly the variance of NSE is
lower as compared with BSE index suggesting a lower risk and a lower
average return at NSE as compared with BSE. It is relevant to note that
NSE was established by the government of India to improve the market
efficiency in Indian stock markets and to break the monopolistic position of
the BSE. NSE index is a more diversified one as compared to the same of
BSE. This can also be due to the unique nature of India‟s equity markets,
the settlement system on BSE was intermittent (Badla system up until 2nd
July 2001) and on NSE it was always cash.
RESULTS:- This study conducts a test of random walk for the BSE and NSE
markets in India, using stock market indexes for the Indian markets. It
employs unit root tests (augmented Dickey-Fuller (ADF)). We perform ADF
test with intercept and no trend and with an intercept and trend. We
further test the series using the Phillips-Perron tests and the KPSS tests for
a confirmatory data analysis. In case of BSE and NSE markets, the null
hypothesis of unit root is convincingly rejected, as the test statistic is more
negative than the critical value, suggesting that these markets do not
show characteristics of random walk and as such are not efficient in the
weak form. We also test using Phillip-Perron test and KPSS test for
confirmatory data analysis and find the series to be stationary. Results are
presented in Table 2. For both BSE and NSE markets, the results are
statistically significant and the results of all the three tests are consistent
suggesting these markets are not weak form efficient.
Results of the study suggest that the markets are not weak form efficient.
DW test, which is a test for serial correlations, has been used in the past
but the explanatory power of the DW can be questioned on the basis that
the DW only looks at the serial correlations on one lags as such may not be
appropriate test for the daily data. Current literature in the area of market
efficiency uses unit root and test of stationarity. This notion of market
efficiency has an important bearing for the fund managers and investment
bankers and more specifically the investors who are seeking to diversify
their portfolios internationally. One of the criticisms of the supporters of
the international diversification into emerging markets is that the
emerging markets are not efficient and as such the investor may not be
able to achieve the full potential benefits of the international
diversification.
Q. 3
Ans:
In finance, the term yield describes the amount in cash that returns to the
owners of a security. Normally it does not include the price variations, at
the difference of the total return. Yield applies to various stated rates of
return on stocks (common and preferred, and convertible), fixed income
instruments (bonds, notes, bills, strips, zero coupon), and some other
investment type insurance products (e.g. annuities).
The term is used in different situations to mean different things. It can be
calculated as a ratio or as an internal rate of return (IRR). It may be used
to state the owner's total return, or just a portion of income, or exceed the
income.
Because of these differences, the yields from different uses should never
be compared as if they were equal. This page is mainly a series of links to
other pages with increased details.
The yield is usually quoted without making any allowance for tax paid by
the investor on the return, and is then known as "gross redemption yield".
It also does not make any allowance for the dealing costs incurred by the
purchaser (or seller).
• If the yield to maturity for a bond is less than the bond's coupon
rate, then the (clean) market value of the bond is greater than the
par value (and vice versa).
• If a bond's coupon rate is less than its YTM, then the bond is selling
at a discount.
• If a bond's coupon rate is more than its YTM, then the bond is selling
at a premium.
• If a bond's coupon rate is equal to its YTM, then the bond is selling
at par.
sum total of the annual effective rate of return earned by an owner of a bond if that bond is held
until its maturity date. This effective return includes the current income generated by the bond as
well as any difference in the face value of the bond and the bond's purchase price. The relationship
of YTM and the bond's coupon rate is as follows: (1) if the purchase price of the bond is greater
than the face value of the bond (purchase made at a premium), the YTM is lower than the coupon
rate (rate printed on bond certificate); (2) if the purchase price of the bond is less than the face
value of the bond (purchase made at a discount), the YTM is higher than the coupon rate; and (3) if
the purchase price of the bond is equal to the face value of the bond, the YTM is equal to the
coupon rate. The equation for the computation of the YTM is as follows:
I = Interest rate paid annually (in dollars) by the bond (coupon rate of the bond)
where: FVOB = face value of bond (amount printed on bond certificate)
CVOB = current value of bond (market value of bond)
n = number of years until bond reaches maturity date. For example, assume the following:
I = 8% coupon rate of the bond (rate printed on bond certificate)
FVOB = $1000 printed on bond certificate
CVOB = $980 market value
n = 30
then:
= 8.15%
Assignment Set- 2
Q.1 With the help of examples explain what is systematic (also called
systemic) and unsystematic risk? All said and done CAPM is not
perfect , do you agree?
Ans:
Systematic risk
In finance, systematic risk, sometimes called market risk, aggregate
risk, or undiversifiable risk, is the risk associated with aggregate
market returns.
Systematic risk should not be confused with systemic risk, the risk of
loss from some catastrophic event that collapses the entire financial
system.
It is the risk which is due to the factors which are beyond the control
of the people working in the market and that's why risk free rate of
return in used to just compensate this type of risk in market. Interest
rates, recession and wars all represent sources of systematic risk
because they affect the entire market and cannot be avoided
through diversification. Whereas this type of risk affects a broad
range of securities, unsystematic risk affects a very specific group of
securities or an individual security. Systematic risk can be mitigated
only by being hedged. Even a portfolio of well-diversified assets
cannot escape all risk.
Example
Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
For example, consider an individual investor who purchases $10,000
of stock in 10 biotechnology companies. If unforeseen events cause
a catastrophic setback and one or two companies' stock prices drop,
the investor incurs a loss. On the other hand, an investor who
purchases $100,000 in a single biotechnology company would incur
ten times the loss from such an event. The second investor's
portfolio has more unsystematic risk than the diversified portfolio.
Finally, if the setback were to affect the entire industry instead, the
investors would incur similar losses, due to systematic risk.
Systematic risk is essentially dependent on macroeconomic factors
such as inflation, interest rates and so on. It may also derive from
the structure and dynamics of the market.
Unsystematic risk
By contrast, unsystematic risk, sometimes called specific risk,
idiosyncratic risk, residual risk, or diversifiable risk, is the company-
specific or industry-specific risk in a portfolio, which is uncorrelated
with aggregate market returns.
Unsystematic risk can be mitigated through diversification, and
systematic risk can not be.
This is the risk other than systematic risk and which is due to the
factors which are controllable by the people working in market and
market risk premium is used to compensate this type of risk.
Total Risk = Systematic risk + Unsystematic Risk
The risk that is specific to an industry or firm. Examples of
unsystematic risk include losses caused by labor problems,
nationalization of assets, or weather conditions. This type of risk can
be reduced by assembling a portfolio with significant diversification
so that a single event affects only a limited number of the assets.
Company- or industry-specific risk as opposed to overall market risk;
unsystematic risk can be reduced through diversification. As the
saying goes, “Don't put all of your eggs in one basket.” Also known
as specific risk, diversifiable risk, and residual risk.
Example
On the other hand, announcements specific to a company, such as a
gold mining company striking gold, are examples of unsystematic
risk.
•
σ
The model assumes that either asset returns are (jointly)
normally distributed random variables or that investors
employ a quadratic form of utility. It is however frequently
observed that returns in equity and other markets are not
normally distributed. As a result, large swings (3 to 6 standard
T
deviations from the mean) occur in the market more
frequently than the normal distribution assumption would
expect.
• The model assumes that the variance of returns is an
adequate measurement of risk. This might be justified under
the assumption of normally distributed returns, but for general
return distributions other risk measures (like coherent risk
measures) will likely reflect the investors' preferences more
adequately. Indeed risk in financial investments is not variance
in itself, rather it is the probability of losing: it is asymmetric in
nature.
ε
• The model assumes that all investors have access to the same
information and agree about the risk and expected return of
all assets (homogeneous expectations assumption).
• The model assumes that the probability beliefs of investors
match the true distribution of returns. A different possibility is
that investors' expectations are biased, causing market prices
to be informationally inefficient. This possibility is studied in
the field of behavioral finance, which uses psychological
assumptions to provide alternatives to the CAPM such as the
overconfidence-based asset pricing model of Kent Daniel,
David Hirshleifer, and Avanidhar Subrahmanyam (2001).
• The model does not appear to adequately explain the variation
in stock returns. Empirical studies show that low beta stocks
may offer higher returns than the model would predict. Some
data to this effect was presented as early as a 1969
conference in Buffalo, New York in a paper by Fischer Black,
Michael Jensen, and Myron Scholes. Either that fact is itself
rational (which saves the efficient-market hypothesis but
makes CAPM wrong), or it is irrational (which saves CAPM, but
makes the EMH wrong – indeed, this possibility makes
volatility arbitrage a strategy for reliably beating the market).
• The model assumes that given a certain expected return
investors will prefer lower risk (lower variance) to higher risk
and conversely given a certain level of risk will prefer higher
returns to lower ones. It does not allow for investors who will
accept lower returns for higher risk. Casino gamblers clearly
pay for risk, and it is possible that some stock traders will pay
for risk as well.
• The model assumes that there are no taxes or transaction
costs, although this assumption may be relaxed with more
complicated versions of the model.
• The market portfolio consists of all assets in all markets, where
each asset is weighted by its market capitalization. This
assumes no preference between markets and assets for
individual investors, and that investors choose assets solely as
a function of their risk-return profile. It also assumes that all
assets are infinitely divisible as to the amount which may be
held or transacted.
• The market portfolio should in theory include all types of
assets that are held by anyone as an investment (including
works of art, real estate, human capital...) In practice, such a
market portfolio is unobservable and people usually substitute
a stock index as a proxy for the true market portfolio.
Unfortunately, it has been shown that this substitution is not
innocuous and can lead to false inferences as to the validity of
the CAPM, and it has been said that due to the inobservability
of the true market portfolio, the CAPM might not be empirically
testable. This was presented in greater depth in a paper by
Richard Roll in 1977, and is generally referred to as Roll's
critique.
• The model assumes just two dates, so that there is no
opportunity to consume and rebalance portfolios repeatedly
over time. The basic insights of the model are extended and
generalized in the intertemporal CAPM (ICAPM) of Robert
Merton, and the consumption CAPM (CCAPM) of Douglas
Breeden and Mark Rubinstein.
• CAPM assumes that all investors will consider all of their assets
and optimize one portfolio. This is in sharp contradiction with
portfolios that are held by individual investors: humans tend to
have fragmented portfolios or, rather, multiple portfolios: for
each goal one portfolio.
Q. 2
What do you understand by arbitrage? Make a critical
comparison between APT & CAPM.
Ans:
In economics and finance, arbitrage is the practice of taking
advantage of a price difference between two or more markets:
striking a combination of matching deals that capitalize upon the
imbalance, the profit being the difference between the market
prices. When used by academics, an arbitrage is a transaction that
involves no negative cash flow at any probabilistic or temporal state
and a positive cash flow in at least one state; in simple terms, it is
the possibility of a risk-free profit at zero cost.
In principle and in academic use, an arbitrage is risk-free; in
common use, as in statistical arbitrage, it may refer to expected
profit, though losses may occur, and in practice, there are always
risks in arbitrage, some minor (such as fluctuation of prices
decreasing profit margins), some major (such as devaluation of a
currency or derivative). In academic use, an arbitrage involves
taking advantage of differences in price of a single asset or identical
cash-flows; in common use, it is also used to refer to differences
between similar assets (relative value or convergence trades), as in
merger arbitrage.
People who engage in arbitrage are called arbitrageurs (IPA: /
ˌɑrbɨtrɑːˈʒɜr/)—such as a bank or brokerage firm. The term is mainly
applied to trading in financial instruments, such as bonds, stocks,
derivatives, commodities and currencies.
Examples
• Suppose that the exchange rates (after taking out the fees for
making the exchange) in London are £5 = $10 = ¥1000 and
the exchange rates in Tokyo are ¥1000 = $12 = £6.
Converting ¥1000 to $12 in Tokyo and converting that $12 into
¥1200 in London, for a profit of ¥200, would be arbitrage. In
reality, this "triangle arbitrage" is so simple that it almost
never occurs. But more complicated foreign exchange
arbitrages, such as the spot-forward arbitrage (see interest
rate parity) are much more common.
• One example of arbitrage involves the New York Stock
Exchange and the Chicago Mercantile Exchange. When the
price of a stock on the NYSE and its corresponding futures
contract on the CME are out of sync, one can buy the less
expensive one and sell it to the more expensive market.
Because the differences between the prices are likely to be
small (and not to last very long), this can only be done
profitably with computers examining a large number of prices
and automatically exercising a trade when the prices are far
enough out of balance. The activity of other arbitrageurs can
make this risky. Those with the fastest computers and the
most expertise take advantage of series of small differences
that would not be profitable if taken individually.
• Economists use the term "global labor arbitrage" to refer to
the tendency of manufacturing jobs to flow towards whichever
country has the lowest wages per unit output at present and
has reached the minimum requisite level of political and
economic development to support industrialization. At present,
many such jobs appear to be flowing towards China, though
some which require command of English are going to India and
the Philippines. In popular terms, this is referred to as
offshoring. (Note that "offshoring" is not synonymous with
"outsourcing", which means "to subcontract from an outside
supplier or source", such as when a business outsources its
bookkeeping to an accounting firm. Unlike offshoring,
outsourcing always involves subcontracting jobs to a different
company, and that company can be in the same country as
the outsourcing company.)
• Sports arbitrage – numerous internet bookmakers offer odds
on the outcome of the same event. Any given bookmaker will
weight their odds so that no one customer can cover all
outcomes at a profit against their books. However, in order to
remain competitive their margins are usually quite low.
Different bookmakers may offer different odds on the same
outcome of a given event; by taking the best odds offered by
each bookmaker, a customer can under some circumstances
cover all possible outcomes of the event and lock a small risk-
free profit, known as a Dutch book. This profit would typically
be between 1% and 5% but can be much higher. One problem
with sports arbitrage is that bookmakers sometimes make
mistakes and this can lead to an invocation of the 'palpable
error' rule, which most bookmakers invoke when they have
made a mistake by offering or posting incorrect odds. As
bookmakers become more proficient, the odds of making an
'arb' usually last for less than an hour and typically only a few
minutes. Furthermore, huge bets on one side of the market
also alert the bookies to correct the market.
• Exchange-traded fund arbitrage – Exchange Traded Funds
allow authorized participants to exchange back and forth
between shares in underlying securities held by the fund and
shares in the fund itself, rather than allowing the buying and
selling of shares in the ETF directly with the fund sponsor. ETFs
trade in the open market, with prices set by market demand.
An ETF may trade at a premium or discount to the value of the
underlying assets. When a significant enough premium
appears, an arbitrageur will buy the underlying securities,
convert them to shares in the ETF, and sell them in the open
market. When a discount appears, an arbitrageur will do the
reverse. In this way, the arbitrageur makes a low-risk profit,
while fulfilling a useful function in the ETF marketplace by
keeping ETF prices in line with their underlying value.
• Some types of hedge funds make use of a modified form of
arbitrage to profit. Rather than exploiting price differences
between identical assets, they will purchase and sell
securities, assets and derivatives with similar characteristics,
and hedge any significant differences between the two assets.
Any difference between the hedged positions represents any
remaining risk (such as basis risk) plus profit; the belief is that
there remains some difference which, even after hedging most
risk, represents pure profit. For example, a fund may see that
there is a substantial difference between U.S. dollar debt and
local currency debt of a foreign country, and enter into a
series of matching trades (including currency swaps) to
arbitrage the difference, while simultaneously entering into
credit default swaps to protect against country risk and other
types of specific risk.
R = R + βI FI + βGDP FGDP + βS FS + ε
• As securities are added to the portfolio, the unsystematic risks
of the individual securities offset each other. A fully diversified
portfolio has no unsystematic risk.
• The CAPM can be viewed as a special case of the APT.
• Empirical models try to capture the relations between returns
and stock attributes that can be measured directly from the
data without appeal to theory.
• Difference in Methodology
CAPM is an equilibrium model and derived from individual
portfolio optimization.
APT is a statistical model which tries to capture sources of
systematic risk. Relation between sources determined by
no Arbitrage condition.
• Difference in Application
APT difficult to identify appropriate factors.
CAPM difficult to find good proxy for market returns.
APT shows sensitivity to different sources. Important for
hedging in portfolio formation.
CAPM is simpler to communicate, since everybody agrees
upon.
Q. 3
Explain in brief APT with single factor model.
Ans:
Arbitrage pricing theory (APT), in finance, is a general theory of
asset pricing, that has become influential in the pricing of stocks.
APT holds that the expected return of a financial asset can be
modeled as a linear function of various macro-economic factors or
theoretical market indices, where sensitivity to changes in each
factor is represented by a factor-specific beta coefficient. The model-
derived rate of return will then be used to price the asset correctly -
the asset price should equal the expected end of period price
discounted at the rate implied by model. If the price diverges,
arbitrage should bring it back into line.
The theory was initiated by the economist Stephen Ross in 1976.
where
• E(rj) is the jth asset's expected return,
• Fk is a systematic factor (assumed to have mean zero),
• bjk is the sensitivity of the jth asset to factor k, also called
factor loading,
• and εj is the risky asset's idiosyncratic random shock with
mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets
and uncorrelated with the factors.
The APT states that if asset returns follow a factor structure then the
following relation exists between expected returns and the factor
sensitivities:
where
• RPk is the risk premium of the factor,
• rf is the risk-free rate,
That is, the expected return of an asset j is a linear function of the
assets sensitivities to the n factors.
Note that there are some assumptions and requirements that have to be fulfilled for the
latter to be correct: There must be perfect competition in the market, and the total
number of factors may never surpass the total number of assets (in order to avoid the
problem of matrix singularity).
As with the CAPM, the factor-specific Betas are found via a linear
regression of historical security returns on the factor in question.
Unlike the CAPM, the APT, however, does not itself reveal the
identity of its priced factors - the number and nature of these factors
is likely to change over time and between economies. As a result,
this issue is essentially empirical in nature. Several a priori
guidelines as to the characteristics required of potential factors are,
however, suggested:
1. their impact on asset prices manifests in their unexpected
movements
2. they should represent undiversifiable influences (these are,
clearly, more likely to be macroeconomic rather than firm-
specific in nature)
3. timely and accurate information on these variables is required
4. the relationship should be theoretically justifiable on economic
grounds
Chen, Roll and Ross (1986) identified the following macro-economic
factors as significant in explaining security returns:
• surprises in inflation;
• surprises in GNP as indicated by an industrial production
index;
• surprises in investor confidence due to changes in default
premium in corporate bonds;
• surprise shifts in the yield curve.
As a practical matter, indices or spot or futures market prices may
be used in place of macro-economic factors, which are reported at
low frequency (e.g. monthly) and often with significant estimation
errors. Market indices are sometimes derived by means of factor
analysis. More direct "indices" that might be used are:
• short term interest rates;
• the difference in long-term and short-term interest rates;
• a diversified stock index such as the S&P 500 or NYSE
Composite Index;
• oil prices
• gold or other precious metal prices
• Currency exchange rates
Single factor model
rj = bj0 + bj1F1 + €j ; j = 1; 2; : : : ; n
where rj is the rate of return on asset (or portfolio) j, F1 denotes the
factor’s value, bj0
and bj1 are parameters, and "j denotes an unobserved random error.
It is assumed that
E[€j l F1] = 0, that is, the expected value of the random error,
conditional upon the value of
the factor, is zero.
APT prediction, single factor model:
The weight λ1 is interpreted as the risk premium associated with the
factor, that is, the risk
premium corresponds to the source of the systematic risk.