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Mahesh Parikh August-09

Arbitrage Pricing Theory

Arbitrage Pricing Theory

Why & What is Need?
1. CAPM establishes relationship between risk and expected return for securities. (Where investors base their decision on comparision of return distribution of alternative portfolios.) 2. Equilibrium predictions of CAPM asserts that investors form portfolio consisting of riskless assets and market porttfolio; combination vary from investor to investor depending upon individual preference for expected risk and return. 3. Equilibrium expected return should be linear function of return on risk free assets (rf) plus market portfolio risk premium [E(rm) rf] which is proportional to the beta of a security. 2

Arbitrage Pricing Theory

What was observed?

1. Small cap stocks outperformed large cap stocks on risk adjusted basis (finding by Mr. Banz) e.g. Tata Sponge Jindal Saw SBT LIC Housing Equity 15 45 18 87 P/E 2.40 6.0 3.80 9.30 Market Price 190 488 465 602 (27.08.09)

2. Low P/E stocks outperformed large P/E stocks; after adjustment for risk (finding by Mr. Banz) P/E Market Price TATA Steel 3.1 440 BPCL 7.5 504 SBI 9.1 1750 Grasim 9.4 2625


Value Stocks Tata Chem, HLL (i.e. stocks with higher book to market value) generated larger returns than Growth Stocks JP Associates, GMR, RPL (stocks with low book-to-market value) on risk adjusted basis. (finding by Mr. Fama & French)
Value Stock
Low Earnings per share growth Low P/E Ratio Low price to book-value ratio High Div. yield Betas tend to be less than one Out of Favour TATA Chem/HLL/Shipping Corp

Growth Stock
High Earnings per share growth High P/E Ratio High price to book-value ratio Low Div. yield Beta tends to be >1 Popular JP/GMR/RPL

Arbitrage Pricing Theory

What does this mean?

1. Are markets not efficient for long period of time?
2. Markets efficient but CAPM (a single factor model) does not capture risk adequately.

Look for Alternative Risk Return Model beyond CAPM



(developed by Mr. Stephen Ross)

Arbitrage Pricing Theory

Arbitrage Pricing Model

Say, there are 2 securities having same risk but Different Expected Return.
Investors to arbitrage / eliminate these differences.

Trading to buy Low Priced and sell High Priced to continue till both are at same expected return

Hence Ross developed a Model explaining i) ii) Assets Risk Expected Return (required return) in terms of sensitivity to each of basic economic factors.

Arbitrage Pricing Theory

Arbitrage Pricing Theory

Arbitrage - arises if an investor can construct a zero investment portfolio with a sure profit Since no investment is required, an investor can create large positions to secure large levels of profit In efficient markets, profitable arbitrage opportunities will quickly disappear

Arbitrage Pricing Theory

Arbitrage Pricing Theory - APT

Three major assumptions:
1. Capital markets are perfectly competitive and no transaction cost. (This assumption makes possible the arbitraging of mispriced securities, thus forcing an equilibrium price) Investors always prefer more wealth to less wealth Various factors give rise to returns on securities and the relation between the security return and that these factor is LINEAR. The stochastic process generating asset returns can be expressed as a linear function of a set of K risk factors or indexes

2. 3.


CAPMs STRONG Assumption are not required

1. 2. 3. 4. Single Period Investment horizon. No Taxes. Investors can freely borrow or lend at rf. Investors select portfolio based on the expected mean and variance of return.

Arbitrage Pricing Theory

The return on any asset i, ri can be expressed as a linear Function of set of M factors/indexes Ri = 10 + i1 I1 + i2 I2 + i3 I3 + . + iM IM + Ei Ri = Return on asset I during a particular time period I = 1, 2 n 10 = Expected Return on asset i, if all risk factors have zero charges (zero returns) ij = Sensitivity of asset is return to the jth index i.e. Reaction in asset is returns to movement in a common factor. (Various systematic risk like interest rate risk etc.) Ij = Value of Jth index j = 1,2, 3 . M i.e. a common factor with zero mean that influences the returns of all assets i.e. Deviation of a systematic risk factor j from its expected value. Ei = Random error term for asset i, with mean of zero and variance E i.e. a unique effect on asset is return that by assumption is completely diversifiable in large portfolios and has a mean of zero N = Nos. of assets Note : 1] APT does not specify the risk factors I1, I2, . Ik that have bearing on asset return. 2] Error Term can be reduced to zero through appropriate diversification.

Arbitrage Pricing Theory

1] Depicts similar to Single Index Model except that under APT there are several indexes/ factors that may have influence on particular securitys index (Factor) 2] These indexes represent systematic influence on securitys return e.g. Growth in GP Changes in Inflation, Interest Rate Risk, Forex Rate Risk etc. ONLY SYSTEMATIC FACTORS ARE IMPORTANT IN PRICING OF SECURITIES. 3] ij element in equation is analogus to

impact that a particular factor has on a particular securitys return e.g. a ij value of 3.0 means that for every 1% change in factor j, security is return is expected to change 3% or thrice the change in the value of Ij.

in Single Index Model. They represent the


Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT)

* ij determines how each asset reacts to the common factor * Each asset may be affected by (though effects are not identical) Growth in GP Changes in expected inflation Changes in the market risk premium Changes in oil prices etc.

* Systematic risks (i.e. Non-diversifiable) factors are important in the pricing of securities.

Arbitrage Pricing Theory

APT assumes that, in equilibrium, the return on a zero-investment, zerosystematic-risk portfolio is zero when the unique effects are diversified away

The expected return on any welldiversified portfolio i (Ei) can be expressed as:

Arbitrage Pricing Theory

E(ri) Where E(ri) = Expected Return on asset I i.e. on well diversified portfolio = Expected Return on asset with zero systematic risk = The risk premium related to each of the common factor e.g. the risk premium related to interest rate risk. = the pricing relationship between the risk premium and asset i i.e. how responsive asset i is to this common factor j i.e. sensitivity or beta coefficient for security i that is associated with index j

0 + 1 i1 + 2 i2 + 3 i3

+ . +

k ik

0 1


Assume, There are two factors which generate returns on assets I. APT Model becomes E (ri) = 0 + 1bi1 + 2bi2


Arbitrage Pricing Theory


Assume, there is only one factor which generates returns on asset i, APT Model boils down to E(ri) = io + ij1 io = Risk Free Return or Zero Beta Security

Slope of arbitrage price line is and intercept is io. The arbitrage price line shows the equilibrium relation between an assets systematic risk and expected return.

Risk Premium
Factor % is Rate of Inflation 1 1 = 0.01 Growth in GNP 2 2 = 0.02 Zero Systematic 3 3 = 0.03 Response to Portfolio bx1 0.50 bx2 1.50 Response to Portfolio by1 2 by2 1.75

Risk Asset E1 = 0 + 1bi1 + 2bi2 = 0.03 + (0.01) bi1 + (0.02) bi2 Ex = 0.03 + (0.01) (0.50) + (0.02) (1.50) = 0.065 = 6.5% Ey = 0.03 + (0.01) bi1 + (0.02) bi2 = 0.03 + (0.01) (2) + (0.02) (1.75) = 0.085 = 8.5%


Arbitrage Pricing Theory


Example of Two Stocks and a Two-Factor Model

= changes in the rate of inflation. The risk premium related to this factor is 1 percent for every 1 (1 0.01) percent change in the rate = percent growth in real GNP. The average risk premium related to this factor is 2 percent for every 1 percent change in the rate (2 0.02) = the rate of return on a zero-systematic-risk asset (zero beta: boj=0) is 3 percent ( 0.03)

Arbitrage Pricing Theory

Example of Two Stocks and a Two-Factor Model

bx1 b y1

= the response of portfolio X to changes in the rate of inflation is 0.50 (bx1 .50)

= the response of portfolio Y to changes in the rate of inflation is 2.00 (by1 2.00) growth rate of real GNP is 1.50

bx 2 = the response of portfolio X to changes in the

b y 2 = the response of portfolio Y to changes in the
growth rate of real GNP is 1.75 (b

(bx 2 1.50)

Arbitrage Pricing Theory

Example of Two portfolios and a Two-Factor Model

Ei 0 1bi1 2bi 2
= 0.03 + (0.01)bi1 + (0.02)bi2 Ex = 0.03 + (0.01)(0.50) + (0.02)(1.50) = 0.065 = 6.5% Ey = 0.03 + (0.01)(2.00) + (0.02)(1.75) = 0.085 = 8.5%


Arbitrage Pricing Theory

Arbitrage Mechanism

For same risks Asset U has higher return than Asset O Asset U is underpriced and assets O is overpriced. Sell asset O or go short on O Buy asset U or go long on U Investor makes Riskless profit Impact Demand on asset U goes up and supply of O also goes up Price of U increases and price of O decreases

Thus, Arbitrage goes on till prices are traded at same level.


Status as on 07-08-09
Cash RIL BHEL EDUCOMP DLF L&T SBI 1995 (buy) Rs. 598500 2180 (buy) Rs. 654000 3905(sale) Rs. 292875 368 (buy) Rs. 588800 1465 (buy) Rs. 586000 1742 (buy) Rs. 459988 Derivative 2000 (sale) Rs. 600000 2200 (sale) Rs. 660000 3891 (buy) Rs. 291825 372 (sale) Rs. 595200 1470 (sale) Rs. 588000 1750 (sale) Rs. 462000 300 300 75 1600 400 264 Lot Size

Arbitrage Pricing Theory

What is Needed Funds Funds Shares Funds Funds Funds


Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT)

Examples of multiple factors expected to have an impact on all assets: Inflation Growth in GNP Major political upheavals Changes in interest rates And many more. Contrast with CAPM insistence that only beta is relevant


Arbitrage Pricing Theory

APT and CAPM Compared

APT applies to well diversified portfolios and not necessarily to individual stocks With APT it is possible for some individual stocks to be mispriced in equilibrium - not lie on the SML APT is more general in that it gets to an expected return and beta relationship without the assumption of the market portfolio APT can be extended to multifactor models
CAPM Nature of relation Number of risk factors Factor risk premium Factor risk sensitivity Zero-beta return Linear 1 [E (RM) Rf] i Rf Linear k j bij 0 24 APT

Arbitrage Pricing Theory

1. While the CAPM is still probably the best available estimate of risk for most corporate investment decision, managers must recognise that their stock prices may fluctuate more than what the standard theory suggests. The market is usually smarter than the individual. Hence managers should weight the evidence of the market over the evidence of experts. Markets function well when participants pursue diverse decision rules and their errors are independent. Markets, however, can become very fragile when participants display herdlike behaviour, imitating one another. It may be futile to identify the cause of a crash or boom because in a non-linear system small things can cause large scale changes. The discounted cash flow model provides an excellent framework for valuation. Indeed, it is the best model for figuring out the expectations embedded in stock prices.






Arbitrage Pricing Theory

Compared to the CAPM, the APT is much more general. It assumes that the return on any stock is linearly related to a set of systematic factors. Ri = ai + bi1 I1 + bi2 I2 + .. + bij Ij + ei The equilibrium relationship according to the APT is E(Ri) = 0 + i1 1 + bi2 2 + . bij I Some studies suggest that, in comparison to the CAPM, the APT explains stock returns better; other studies hardly find any difference between the two.


Arbitrage Pricing Theory

1] Three portfolio with risk return characteristics as under Portfolio A B U E(ri) 10.6 13.4 15.0 Risk (i) 0.80 1.20 1.00

Portfolio U offers returns disproportionate to risk Portfolios A & B returns are commensurate with the risk Opportunity to profit Riskless arbitrage conversion. How? Construct Portfolio F with same risk level as U This can be done by investing equal amounts in Portfolio A & B 0.50 X beta of A + 0.50 X beta of B = 0.50 X 0.80 + 0.50 X 1.20 = 0.40 + 0.60 = 1.00

of Portfolio F is

Return on Portfolio F is = 0.50 X 10.6 + 0.50 X 13.4 = 12% This return is in line with the Portfolios risk.


Arbitrage Pricing Theory

2] How arbitrage Portfolio can be constructed to benefit from differential return given by portfolio F & U having same level of risk. Ans. Strategy is short sell F Go Long on U Portfolio Investment(Rs.) Return (Rs. ) F 10,000 - 1200 U - 10,000 + 1500 Arbitrage Portfolio 0 + 300 Arbitrage Portfolio O i) ii) iii) iv) v) vi) Short sell F Realise Rs. 10,000 i.e. ve value of investment Invest in U Invest Rs. 10,000 Expected Return on F & U @ 12% and 15% Net Return on Arbitrage Rs. 300 Since eta of F & U are equal but opposite in value, Beta of arbitrage portfolio is zero. Arbitrage Portfolio offers profit without any Net Investment or Risk.

Risk (i) -1 +1 0

Arbitrage Pricing Theory

EXAMPLES (two factor Arbitraging Process)

Returns generated by two indices or factors as per following pricing relation E(ri) = 5 + 7i1 + 4 i2

A B O E(ri) 15.4 16.6 14.0 Risk (i1) 0.80 1.20 1.00 Risk (i2) 1.20 0.80 1.00

A & B are correctly priced. Return O is not commensurate with risk. Scope of arbitrate Construct Portfolio F (same risk as O) E(rf) = (0.50 X 15.4) + (0.50 X 16.6) = 16 Bf1 = (0.50 x 0.80) + (0.5 X 1.20) = 1.0 Bf2 = (0.50 X 1.20) + (0.5 X 0.80) = 1.0 Portfolio F has the same systematic risk as portfolio O Arbitrage portfolio can be created by selling overprice i.e. O and going long on F.


Arbitrage Pricing Theory

Three portfolios as under:Portfolio E(ri) Bi1 Risk Bi2 Risk A 15.4 0.80 1.20 B 16.6 1.20 0.80 O 14.0 1.00 1.00 A & B are correctly priced. Return on O is not commensurate with underlying risk measured by Bil & Biz We can construct a Portfolio F which also has same risk characteristic as portfolio O. This portfolio f can be constructed by combining portfolios A & B in equal proportion. i.e. E(rf) = (0.50)(15.4) + (0.50)(16.6)= 7.7 + 8.3 = 16 F1 = (0.50)(0.80) + (0.50)(1.20) = 0.4 + 0.6 = 1 F2 = (0.50)(1.20) + (0.50)(0.80) = 0.6 + 0.4 = 1


Arbitrage Pricing Theory

Portfolio F has same systematic risk as portfolio O differs on higher return (i.e. 16% & not 14%). This offers an arbitrage opportunity. Portfolio Investment Return Risk Bi1 Risk Bi2 O -10,000 -1400 -1 -1 F 10,000 +1600 +1 +1 ________ ________ ____ ______ 0 200 0 0


1. Consider the following data relating to beta and expected return of two portfolios:Portfolio Return % Beta A 14 1.0 B 16 1.0 Given one factor arbitrage pricing model is E(ri) = 6 + 8 i1 show the arbitrage opportunity, if any, can be exploited. Ans.: E (rA) = 6 + 8 i1 = 6 + 8(1) = 14 E (rB) = 6 + 8 i1 = 6 + 8(1) = 14 The return from B is higher @16% than 14% expected. Hence, we should go long on B & short sell A suppose we have Rs. 1,00,000/Portfolio Investment Return Risk (Beta) A -1,00,000 -14,000 1 B +1,00,000 +16,000 1 +2,000