ARBITRAGE PRICING

THEORY & SHARPE

INDEX MODEL
Rahul Savalia
Mithilesh Shukla
Arbitrage Pricing Theory (APT)
 Based on the law of one price. Two items that are
the same cannot sell at different prices
 If they sell at a different price, arbitrage will take
place in which arbitrageurs buy the good which is
cheap and sell the one which is higher priced till all
prices for the goods are equal
APT
 In APT, the assumption of investors utilizing a
mean-variance framework is replaced by an
assumption of the process of generating security
returns.
 APT requires that the returns on any stock be
linearly related to a set of indices.
 In APT, multiple factors have an impact on the
returns of an asset in contrast with CAPM model
that suggests that return is related to only one
factor, i.e., systematic risk
 Factors that have an impact the returns of all assets
may include inflation, growth in GNP, major
political upheavals, or changes in interest rates
 ri = ai + bi1F1 + bi2F2 + …+bikFk + ei
 Given these common factors, the bik terms
determine how each asset reacts to this common
factor.
 While all assets may be affected by growth in
GNP, the impact will differ.
 Which firms will be affected more by the growth in
GNP?
 The APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic risk portfolio
is zero, when the unique effects are diversified
away:
 E(ri) = 0 + 1bi1 + 2bi2 + … + kbik
Single Index Model-Assumptions
 Known economist William Sharpe developed the single
index model.
 According to this model we make following assumptions:
a) We summarize all relevant economic factors by one
macro-economic indicator and assume that it moves the
security market as a whole.
b) Beyond this common effect, all remaining uncertainty in
stock return is firm specific; i.e. there is no other source
of correlation between securities.
c) Stocks co vary together only because of their common
relationship to the market index.
Single Index Model
 This model relates returns on each security to the
returns on a common index.
 A broad index of common stock is generally used
for this purpose.
 The common index can be BSE 100 stocks, Nifty
50 stocks so on and so forth.
Single Index Model- Returns
The single index model can be expressed by the following equation.

RRi i i i i iRRMM eei i

Ri= the return on security i

RM=the return on the market index
αi=that part of security i’s return independent of market performance.
Βi= a constant measuring the expected change in the dependent
variable, Ri, given a change in the independent variable RM
ei= random residual error.
Single Index Model- Returns
 Single index model divides return into two
components
1. a unique part, αi
2. a market-related part, βiRM
 The unique part is a micro event, affecting an
individual company but not all companies in general.
 The market related part, on the other hand, is a macro
event that is broad based and affects all (or most) of
the firms.
 The error term ei captures the difference between the
return that actually occurs and return expected to
occur given a market index return.
Measuring Systematic Risk
 Beta (β) measures a stock’s market (or systematic)
risk. It shows the relative volatility of a given stock
compared to the average stock. An average stock (or
the market portfolio) has a beta = 1.0.
 Beta shows how risky a stock is if the stock is held in
a well-diversified portfolio.

 β=1 → stock has average risk.

 β>1 → stock is riskier than average.
 β<1 → stock is less risky than average.
 β=0 → risk free assets (e.g., Treasury bills)
Single Index Model- Co variance
 In the single index model, the covariance between two
stocks depends only on the market risk Therefore
covariance between two securities can be written as
ijij iiM2M2

 Note that stock i’s beta has two components:

 Covariance of returns between stock i and market

portfolio.
 Variance of return on market portfolio NO  i
2

 NO variance of return on stock i 

Single Index Model- Risk
 In Single Index Model, the total risk of a security,
as measured by its variance, consists of two
components: market risk and unique risk

 22
  
22
ii   Mi
22
  22
M  ei
ei
i

= Market risk+ company specific risk

Single Index Model- Risk
 This single security variance can be extrapolated
for finding the minimum variance set of
portfolios.
 22   22 22   22
p  p M  ep
p p M ep

i.e. Total portfolio variance=Portfolio market risk+

portfolio residual variance
Reward to Risk Ratio
 We can vary the amount invested in each type of asset
and get an idea of the relation between portfolio
expected return and beta:
E ( RP )  R f
Reward - to - Risk Ratio 
P

 It estimates the expected risk premium per unit of risk.

 We can also calculate the reward to risk ratio for all
individual securities.
What happens if two securities have different
reward-to-risk ratios?
E ( RA )  R f E ( RB )  R f

A B
 Investors would only buy the securities (portfolios) with a higher
reward-to-risk ratio. Here, it would be A.
 Eventually, all securities will have the same reward-to-risk ratio.
 Because the reward-to-risk ratio is the same for all securities, it must
hold for the market portfolio too.
 Result:

E ( RA )  R f E ( RB )  R f E ( RM )  R f
  ...   E ( RM )  R f
A B M
Thank You