Return and Risk :

CAPM and APT

Reference: RWJ Chp. 11

 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.
 Factor Models: Announcements,
Surprises, and Expected Returns
• The return on any security consists of two parts.
– First the expected returns
– Second is the unexpected or risky returns.
• A way to write the return on a stock in the
coming month is:
R = R +U
where
R is the expected part of the return
U is the unexpected part of the return
 Factor Models: Announcements,
Surprises, and Expected Returns
• Any announcement can be broken down into two
parts, the anticipated or expected part and the
surprise or innovation:
• Announcement = Expected part + Surprise.
• The expected part of any announcement is part of
the information the market uses to form the
expectation, R of the return on the stock.
The surprise is the news that influences the
unanticipated return on the stock, U.
 Risk: Systematic and Unsystematic
• A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
• An unsystematic risk is a risk that specifically affects a single
asset or small group of assets.
• Unsystematic risk can be diversified away.
• Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
• On the other hand, announcements specific to a company,
such as a gold mining company striking gold, are examples of
unsystematic risk.
 Risk: Systematic and Unsystematic
We can break down the risk, U, of holding a stock into two
components: systematic risk and unsystematic risk:
σ
R = R +U
Total risk; U
becomes
ε R = R+m+ε
where
Nonsystematic Risk;
ε m is the systematic risk
Systematic Risk; m ε is the unsystematic risk

n
 Systematic Risk and Betas

• The beta coefficient, β , tells us the response of the

stock’s return to a systematic risk.
• In the CAPM, β measured the responsiveness of a
security’s return to a specific risk factor, the return on the
market portfolio.

Cov( Ri , RM )
βi =
σ ( RM )
2

• We shall now consider many types of systematic risk.

 Systematic Risk and Betas
• For example, suppose we have identified three
systematic risks on which we want to focus:
1. Inflation
2. GDP growth
3. The dollar-euro spot exchange rate, S($,€)
• Our model is:
R = R+m+ε
R = R + βI FI + βGDP FGDP + βS FS + ε
βI is the inflation beta
βGDP is the GDP beta
βS is the spot exchange rate beta
ε is the unsystematic risk
 Systematic Risk and Betas: Example
R = R + βI FI + βGDP FGDP + βS FS + ε
• Suppose we have made the following estimates:
1. β I = -2.30
2. β GDP = 1.50
3. β S = 0.50.
• Finally, the firm was able to attract a “superstar” CEO
and this unanticipated development contributes 1% to
ε = 1%
the return.

R = R − 2.30 × FI + 1.50 × FGDP + 0.50 × FS + 1%

 Systematic Risk and Betas: Example
R = R − 2.30 × FI + 1.50 × FGDP + 0.50 × FS + 1%

We must decide what surprises took place in the systematic

factors.
If it was the case that the inflation rate was expected to be by
3%, but in fact was 8% during the time period, then
FI = Surprise in the inflation rate
= actual – expected
= 8% - 3%
= 5%

R = R − 2.30 × 5% + 1.50 × FGDP + 0.50 × FS + 1%

 Systematic Risk and Betas: Example
R = R − 2.30 × 5% + 1.50 × FGDP + 0.50 × FS + 1%

If it was the case that the rate of GDP growth

was expected to be 4%, but in fact was 1%,
then
FGDP = Surprise in the rate of GDP growth
= actual – expected
= 1% - 4%
= -3%
R = R − 2.30 × 5% + 1.50 × (−3%) + 0.50 × FS + 1%
 Systematic Risk and Betas: Example

R = R − 2.30 × 5% + 1.50 × (−3%) + 0.50 × FS + 1%

If it was the case that dollar-euro spot exchange rate,

S($,€), was expected to increase by 10%, but in fact
remained stable during the time period, then
FS = Surprise in the exchange rate
= actual – expected
= 0% - 10%
= -10%

R = R − 2.30 × 5% + 1.50 × (−3%) + 0.50 × (−10%) + 1%

 Systematic Risk and Betas: Example
R = R − 2.30 × 5% + 1.50 × (−3%) + 0.50 × FS + 1%

Finally, if it was the case that the expected return

on the stock was 8%, then

R = 8%

R = 8% − 2.30 × 5% + 1.50 × (−3%) + 0.50 × (−10%) + 1%

R = −12%
 Portfolios and Factor Models

• Now let us consider what happens to portfolios of stocks when

each of the stocks follows a one-factor model.
• We will create portfolios from a list of N stocks and will capture
the systematic risk with a 1-factor model.
• The ith stock in the list have returns:

Ri = R i + βi F + εi
 Relationship Between the Return on
the Common Factor & Excess Return

Excess Ri − R i = βi F + εi
return
If we assume
that there is no
unsystematic
εi risk, then ε i =
0

The return on the factor F

 Relationship Between the Return on
the Common Factor & Excess Return

Excess
return
If we assume
Ri − R i = βi F that there is no
unsystematic
risk, then ε i =
0

The return on the factor F

 Relationship Between the Return on
the Common Factor & Excess Return

Excess
return β A = 1.5 β B = 1.0
Different
securities will
βC = 0.50 have different
betas

The return on the factor F

 Portfolios and Diversification
• We know that the portfolio return is the
weighted average of the returns on the
individual assets in the portfolio:

RP = X 1 R1 + X 2 R2 +  + X i Ri +  + X N RN
Ri = R i + βi F + εi
RP = X 1 ( R1 + β1 F + ε1 ) + X 2 ( R 2 + β2 F + ε2 ) +
 + X N ( R N + βN F + εN )

RP = X 1 R1 + X 1 β1 F + X 1ε1 + X 2 R 2 + X 2 β2 F + X 2 ε2 +
 + X N R N + X N βN F + X N εN
 Portfolios and Diversification
The return on any portfolio is determined by three sets of parameters:

1. The weighed average of expected returns.

2. The weighted average of the betas times the factor.
3. The weighted average of the unsystematic risks.
RP = X 1 R 1 + X 2 R 2 +  + X N R N
+ ( X 1 β1 + X 2 β2 +  + X N β N ) F
+ X 1ε1 + X 2 ε2 +  + X N ε N
In a large portfolio, the third row of this equation
disappears as the unsystematic risk is diversified away.
 Portfolios and Diversification
So the return on a diversified portfolio is
determined by two sets of parameters:
1. The weighed average of expected returns.
2. The weighted average of the betas times
the factor F.
RP = X 1 R 1 + X 2 R 2 +  + X N R N
+ ( X 1 β1 + X 2 β2 +  + X N β N ) F

In a large portfolio, the only source of uncertainty is the

portfolio’s sensitivity to the factor.
 Betas and Expected Returns
RP = X 1 R1 +  + X N R N + ( X 1 β1 +  + X N β N ) F

RP βP

Recall that and

R P = X 1 R1 +  + X N R N β P = X 1 β1 +  + X N β N

The return on a diversified portfolio is the sum of the expected

return plus the sensitivity of the portfolio to the factor.

RP = R P + β P F
 Relationship Between β & Expected
Return
• If shareholders are ignoring unsystematic
risk, only the systematic risk of a stock can
be related to its expected return.

RP = R P + βP F
Relationship Between β & Expected
Return
Expected return SML

D
A B
RF
C

R = RF + β ( R P − RF )
 The Capital Asset Pricing Model and
the Arbitrage Pricing Theory
• APT applies to well diversified portfolios and not
necessarily to individual stocks.
• With APT it is possible for some individual
stocks to be mispriced - 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.