Factor models and Arbitrage

pricing theory
Prof. Akhil Shetty
Introduction
► In many respects, the CAPM (1964) has been one of the most useful— and frequently
used—financial economic theories ever developed
► However, some of the empirical studies pointed out deficiencies in the model as an
explanation of the link between risk and return
► There was mixed support for a positive linear relationship between rates of return and
systematic risk for portfolios of stock, with some recent evidence indicating the need
to consider additional risk variables or a need for different risk proxies
► In comparison to single- factor models (typically based on a market risk factor),
multifactor models offer increased explanatory power and flexibility
► Arbitrage pricing theory(APT) and various multi factor model including Fama – French,
Carhart, Macroeconomic based, Fundamental based etc where developed after the
introduction of CAPM single factor model
► Multifactor models have come to dominate investment practice, having demonstrated
their value in helping asset managers and asset owners address practical tasks in
measuring and controlling risk
Limitation of CAPM
► Single-factor model
► Only risk associated with Market is priced in the CAPM
► Estimation of beta risk:
► A long history of returns (three to five years) is required to estimate beta risk
► The historical state of the company, however, may not be an accurate
representation of the current or future state of the company
► Proxy for a market portfolio
► In the absence of a true market portfolio, market participants generally use
proxies
► These proxies, however, vary among analysts, the country of the investor, etc.
and generate different return estimates for the same asset, which is
impermissible in the CAPM
Limitation of CAPM
► Market portfolio
► The true market portfolio according to the CAPM includes all assets, financial and
nonfinancial, which means that it also includes many assets that are not investable,
such as human capital and assets in closed economies
► Homogeneity in investor expectations
► The CAPM assumes that homogeneity exists in investor expectations for the model to
generate a single optimal risky portfolio (the market)
► Investors can process the same information in a rational manner and arrive at
different optimal risky portfolios
► The CAPM is a poor predictor of returns
► If the CAPM is a good model, its estimate of asset returns should be closely
associated with realized returns
► However, empirical support for the CAPM is weak. In other words, tests of
the CAPM show that asset returns are not determined only by systematic risk
 Arbitrage Pricing Theory (APT)
► Arbitrage Pricing Theory (APT) are based on the same principle as the CAPM but expand the
number of risk factors which capture systematic risk
► APT was developed by Stephen Ross in 1976 and he proposed a linear relationship between
expected return and risk
► APT 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 factors, where sensitivity to changes in each
factor is represented by a factor-specific beta coefficient
► E(Ri) = RF + λ1*βp,1 + λ2*βp,2 + ... + λK*βp,K
where
E(Ri) = the expected return of asset i
RF = the risk- free rate
λj = the risk premium (expected return in excess of the risk- free rate) for Risk Factor j
βp,j = the sensitivity of the asset to Risk Factor j
K = the number of Risk Factors
Arbitrage Pricing Theory (APT)
► APT makes less strong assumption as compared to CAPM. The APT make 3 key
assumptions
► A factor model describes asset return
► There are many assets, so investors can form a well diversified portfolio that eliminate asset
specific risk
► No arbitrage opportunities exist among well diversifies portfolio
► CAPM only uses one factor to determine the required rate of return – the market
factor
► While APT can use several factors like Inflation, Interest rate, Business Cycle
uncertainty, Foreign currency etc
► Although it is theoretically elegant, flexible, and superior to the CAPM, APT is not
commonly used in practice because it does not specify any of the risk factors and it
becomes difficult to identify risk factors and estimate betas for each asset in a portfolio
Calculation using Arbitrage Pricing Theory (APT)
► Following information regarding ABL corporation was gathered in order to find
expected return using Arbitrage Pricing Theory
► Risk free rate = 6%
► GDP factor beta = 0.9
► Consumer sentiment factor beta = 1.2
► Foreign exchange factor beta = 0.34
► GDP risk Premium = 2%
► Consumer sentiment risk premium = 4%
► Foreign exchange risk premium = -0.5%
 Multifactor Model (Fama French)
► Fama and French (1992) proposed that three factors seem to explain asset returns better
than just systematic risk
► Rit − RF = αi +bi1(RMRF)+bi2*SMB +bi3*HML + εi
where
Rit and RF = the return on the asset and the risk- free rate of return respectively
αi = “alpha” or return in excess of that expected given the portfolio’s level of systematic risk
(assuming the three factors capture all systematic risk i.e abnormal return above theoretical
expected return)
bi = the sensitivity of the asset to the given factor
RMRF = the return on a equity index in excess of the risk free rate
SMB = small minus big, a size (market capitalization) factor; SMB is the average return on three
small- cap portfolios minus the average return on three large- cap portfolios
HML = high minus low, the average return on two high book- to- market portfolios (Value stock)
minus the average return on two low book- to- market portfolios
εi = an error term that represents the portion of the return to the asset, not explained by the
model
 Multifactor Model (Fama French)
► The Fama-French model aims to describe stock returns through three factors:
► Market risk
► the outperformance of small-cap companies relative to large-cap companies
► the outperformance of high book-to-market value companies (Value stock) versus
low book-to-market value companies
► The rationale behind the model is that high value and small-cap companies tend to
regularly outperform the overall market
► Value stock are those who have low price to book value (i.e High Book value to
price) compared to benchmark
Multifactor Model (Carhart)
► The Carhart four- factor model (1997) is an extension of the three- factor model
developed by Fama and French (1992) to include a momentum factor
► Rit − RF = αi +bi1(RMRF)+bi2*SMB +bi3*HML +bi4*WML + εi
where
Rit and RF = the return on the asset and the risk- free rate of return respectively
αi = “alpha” or return in excess of that expected given the portfolio’s level of systematic risk (assuming
the three factors capture all systematic risk)
bi = the sensitivity of the asset to the given factor
RMRF = the return on a equity index in excess of the risk free rate
SMB = small minus big, a size (market capitalization) factor; SMB is the average return on three small- cap
portfolios minus the average return on three large- cap portfolios
HML = high minus low, the average return on two high book- to- market portfolios (Value stock) minus the
average return on two low book- to- market portfolios
WML = winners minus losers, a momentum factor; WML is the return on a portfolio of the past year’s
winners minus the return on a portfolio of the past year’s losers
εi = an error term that represents the portion of the return to the asset, not explained by the model
Multifactor Model (Carhart)
► The Carhart aims to describe stock returns through three factors:
► Market risk
► the outperformance of small-cap companies relative to large-cap companies
► the outperformance of high book-to-market value companies (Value stock) versus
low book-to-market value companies
► Stocks whose prices have been rising, commonly referred to as “momentum” stocks
► Size, value, and momentum are common themes in equity portfolio construction, and
all three factors continue to have robust uses in active management risk decomposition
and return attribution
Calculation using Fama – French & Carhart Model
► Following information regarding ABL corporation was gathered in order to find
expected return using Fama – French & Carhart Model
► Risk free rate = 6%
► Market risk factor beta = 1.1
► SMB factor beta = 0.2
► HML factor beta = 0.15
► WML factor beta = 0.05
► Market return (Rm)= 11%
► Average Return of Small Cap = 16%
► Average Return of Large Cap = 11%
► Average Return of Value stock = 14%
► Average Return of Growth Cap = 12%
► Average Return of Winner stock = 26%
► Average Return of Loser stocks = - 18%
Multifactor Model (Macroeconomic-Based
Risk Factor)
► One particularly influential model was developed by Chen, Roll, and Ross (1986), who
hypothesized that security returns are governed by a set of broad economic influences
in the following fashion
► Rit =ai + {bi1RMt +bi2MPt +bi3DEIt +bi4UIt +bi5UPRt +bi6UTSt}+ eit
Where
RM = the return on a value-weighted index of NYSE-listed stocks
MP = the monthly growth rate in U.S. industrial production
DEI = the change in inflation; measured by the U.S. consumer price index
UI = the difference between actual and expected levels of inflation
UPR = the unanticipated change in the bond credit spread (Baa yield – RFR)
UTS = the unanticipated term structure shift (long-term less short-term RFR)
Calculation using Macroeconomic-Based Risk Factor
► Following information regarding ABL corporation was gathered in order to find expected
return using Macroeconomic-Based Risk Factor
► Risk free rate = 6%
► Market risk factor beta = 1.1
► Industrial production risk factor = 1.4
► Inflation risk factor = 1.2
► Unanticipated inflation risk factor = 0.3
► Bond credit spread risk factor = 0.75
► Term structure risk factor = 0.8
► Market return (Rm)= 11%
► Monthly growth rate in U.S. industrial production = 0.8%
► the change in U.S consumer price index = 1%
► Expected levels of inflation = 1.2%
► Unanticipated change in the bond credit spread = 0.5%
► Unanticipated term structure shift = -0.75%