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and Control

Prepared By:
Dr. H. M. Mosarof Hossain
Department of Finance
University of Dhaka

Chapter Nine: Multifactor Models of Risk and
Multifactor models: an overview
In mathematical finance, multiple factor models
are asset pricing models that can be used to
estimate the discount rate for the valuation of
financial assets. They are generally extensions
of the single-factor CAPM.
A multi-factor model is a financial model that
employs multiple factors in its computations to
explain market phenomena and/or equilibrium
asset prices.

The multi-factor model can be used to explain
either an individual security or a portfolio of
securities. It does so by comparing two or more
factors to analyze relationships between variables
and the resulting performance.

Multi-factor models are used to construct portfolios

with certain characteristics, such as risk, or to track
indexes. When constructing a multi-factor model, it
is difficult to decide how many and which factors to
include. Also, models are judged on historical
numbers, which might not accurately predict future
values. 3
Categories of Multi-Factor Models
Multi-factor models can be divided into three
categories: macroeconomic models, fundamental
models and statistical models. Macroeconomic
models compare a security's return to such factors
as employment, inflation and interest.
Fundamental models analyze the relationship
between a security's return and its underlying
financials, such as earnings. Statistical models
are used to compare the returns of different
securities based on the statistical performance of
each security in and of itself.

Arbitrage Pricing Theory
Arbitrage pricing theory predicts a security market
line linking expected returns to risk, that relies on
three key propositions: (i) security returns can be
described by a factor model; (ii) there are sufficient
securities to diversify away idiosyncratic risk; and
(iii) well-functioning security markets do not allow
for the persistence of arbitrage opportunities.

Arbitrage Pricing Theory
It is a general theory of asset pricing that 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 the model. If the price
diverges, arbitrage should bring it back into line.

Arbitrage Pricing Theory
Arbitrage Pricing Theory Equation and Example
APT states that the expected return on a stock or other
security must adhere to the following relationship:
Expected return = r(f) + b(1) x rp(1) + b(2) x rp(2) + ...
+ b(n) x rp(n)
r(f) = the risk-free interest rate
b = the sensitivity of the asset to the particular factor
rp = the risk premium associated with the particular factor
The number of factors will range depending on the
analysis. There can be a few or dozens; it depends on
which factors an analyst chooses for the analysis.

Arbitrage Pricing Theory
In addition, the exact factors do not have to be the same
across analyses. As an example, assume a stock is being
analyzed by following four factors have been identified, along
with the stocks sensitivity to each factor and the risk premium
associated with each factor:
Gross domestic product growth: b = 0.6, rp = 4%
Inflation rate: b = 0.8, rp = 2%
Gold prices: b = -0.7, rp = 5%
Market index return: b = 1.3, rp = 9%
The risk-free rate is 3%.
Using the above APT formula, the expected return is
calculated as:
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%)
+ (1.3 x 9%) = 15.2%
Arbitrage Pricing Theory Assumptions
i. The theory is based on the principle of capital
market efficiency and hence assumes all market
participants trade with the intention of profit

ii. It assumes no arbitrage exists and if it occurs

participants will engage to benefit out of it and bring
back the market to equilibrium levels.

iii. It assumes markets are frictionless, i.e. there are

no transaction costs, no taxes, short selling is
possible and an infinite number of securities is
available. 9
Arbitrage Pricing Theory Benefits
i. APT model is a multi-factor model. So, the expected
return is calculated taking into account various factors
and their sensitivities that might affect the stock price
movement. Thus, it allows selection of factors that affect
the stock price largely and specifically.
ii. APT model is based on arbitrage free pricing or market
equilibrium assumptions which to a certain extent result in
a fair expectation of the rate of return on the risky asset.
iii. APT based multi-factor model places emphasis on the
covariance between asset returns and exogenous factors,
unlike CAPM. CAPM places emphasis on the covariance
between asset returns and endogenous factors.
Arbitrage Pricing Theory Benefits
iv. APT model works better in multi-period cases as
against CAPM which is suitable for single period
cases only.
v. APT can be applied to the cost of capital and
capital budgeting decisions.
vi. The APT model does not require any assumption
about the empirical distribution of the asset returns,
unlike CAPM which assumes that stock returns follow
a normal distribution and thus APT a less restrictive

Arbitrage Pricing Theory Limitations
1. The model requires short listing of factors that impact the stock
under consideration. Finding and listing all factors can be a difficult
task and runs a risk of some or the other factor being ignored. Also,
the risk of accidental correlations may exist which may cause a factor
to become substantial impact provider or vice versa.
2. The expected returns for each of these factors will have to be
arrived at, which depending on the nature of the factor, may or may
not be easily available always.
3. The model requires calculating sensitivities of each factor which
again can be an arduous task and may not be practically feasible.
4. The factors that affect the stock price for a particular stock may
change over a period of time. Moreover, the sensitivities associated
may also undergo shifts which need to be continuously monitored
making it very difficult to calculate and maintain.

A Multifactor APT
1. Multifactor models seek to improve the explanatory power of
single-factor models by explicitly accounting for the various
systematic components of security risk. These models use indicators
intended to capture a wide range of macroeconomic risk factors.
2. A multifactor APT generalizes the single-factor model to
accommodate several sources of systematic risk. The
multidimensional security market line predicts that exposure to each
risk factor contributes to the security's total risk premium by an
amount equal to the factor beta times the risk premium of the factor
portfolio that tracks that source of risk.
3. A multifactor extension of the single-factor CAPM, the ICAPM, is a
model of the risk–return trade-off that predicts the same
multidimensional security market line as the APT. The ICAPM
suggests that priced risk factors will be those sources of risk that lead
to significant hedging demand by a substantial fraction of investors.
Fama and French Three-Factor Model
One widely used multi-factor model is the Fama and
French three-factor model. The Fama and French
model has three factors: size of firms, book to market
values and excess return on the market. In other
words, the three factors used are SMB (small minus
big), HML (high minus low) and the portfolio's return
less the risk free rate of return. SMB accounts for
publicly traded companies with small market caps
that generate higher returns, while HML accounts for
values stocks with high book-to-market ratios that
generate higher returns in comparison to the market.

Fama and French Three-Factor Model
Rit = αi + βiMRMt + βiSMBSMBt + βiHML HMLt + еit

R= Rf+β3(Km-Rf)+bs(SMB)+bv.HML+α

SMB= Small minus big, i.e., the return of a portfolio of small stocks
in excess of the return on a portfolio of large stocks.

HML= High minus low, i.e., he return of a portfolio of stocks with a

high book to market ratio in excess of the return on a portfolio of
stocks with a low book to market ratio.