Professional Documents
Culture Documents
1
Factor Models: Announcements, Surprises, and Expected
Returns
Risk: Systematic and Unsystematic
Systematic Risk and Betas
Portfolios and Factor Models
Betas and Expected Returns
The Capital Asset Pricing Model and the Arbitrage Pricing
Theory
Parametric Approaches to Asset Pricing
2
Arbitrage Pricing Theory
Arbitrage Pricing Theory (APT) is a valuation model
alternative to CAPM.
The expected return on an asset is a function of
many factors and the sensitivity of the stock to these
factors
Arbitrage arises when investors take opportunities of
miss priced shares with equal risks exposures.
In efficient markets, profitable arbitrage opportunities
will quickly disappear.
3
Arbitrage Pricing Theory
4
Arbitrage Pricing Theory
5
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
6
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.
7
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.
8
Risk: Systematic and Unsystematic
We can break down the risk, U, of holding a stock into two
components: systematic risk and unsystematic risk:
σ
Total risk; U R = R +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 9
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 2 ( RM )
We shall now consider many types of systematic
risk.
10
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
R = R +m +ε
spot exchange R = R + βI FI + βGDP FGDP + βS FS + ε
rate, S($,€)
Our model is: βI is the inflation beta
βGDP is the GDP beta
βS is the spot exchange rate beta
ε is the unsystematic risk
11
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
the return.
ε = 1%
R = 8%
Ri = Ri + βi F + εi
17
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
18
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
19
Relationship Between the Return on the
Common Factor & Excess Return
Excess
return βA = 1.5 β B = 1.0
Different
securities will
βC = 0.50 have different
betas
20
Portfolios and Diversification
We know that the portfolio return is the weighted average of the
returns on the individual assets in the portfolio:
RP = X1 R1 + X 2 R2 + + Xi Ri + + X N RN
Ri = Ri + βi F + εi
RP = X1 ( R1 + β1 F + ε1 ) + X2 ( R2 + β2 F + ε2 ) +
+ X N ( RN + βN F + εN )
RP = X1 R1 + X1 β1 F + X1 ε1 + X2 R2 + X 2 β2 F + X 2 ε2 +
+ X N RN + X N βN F + X N εN
21
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 = X1 R1 + X2 R2 + + X N RN
+ ( X1 β1 + X2 β2 + + X N βN ) F
+ X1 ε1 + X2 ε2 + + X N εN
In a large portfolio, the third row of this equation disappears as the
unsystematic risk is diversified away.
22
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 = X1 R1 + X 2 R2 + + X N RN
+ ( X1 β1 + X 2 β2 + + X N βN ) F
RP = X1 R1 + + X N RN + ( X1 β1 + + X N βN ) F
RP βP
Recall that and
RP = X1 R1 + + X N RN βP = X1 β1 + + X N βN
The return on a diversified portfolio is the sum of the
expected return plus the sensitivity of the portfolio to
the factor.
RP = RP + βP F
24
Relationship Between β & Expected Return
25
Relationship Between β & Expected Return
Expected return
SML
D
A B
RF
C
R = RF + β ( RP −RF )
26
The Capital Asset Pricing Model and the
Arbitrage Pricing Theory
The CAPM theory is really just a simplified version of
the APT, whereby the only factor considered is the risk
of a particular stock relative to the rest of the stock
market - as described by the stocks beta.
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.
27
Summary and Conclusions
The APT assumes that stock returns are generated according to
factor models such as:
R = R + βI FI + βGDP FGDP + βS FS + ε
As securities are added to the portfolio, the unsystematic risks of the
individual securities offset each other. A fully diversified portfolio has
no unsystematic risk.
The CAPM can be viewed as a special case of the APT.
28