The Arbitrage Pricing Theory

Chaiporn Vithessonthi
School of Business, Monash University Malaysia
Email: [email protected]

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The Arbitrage Pricing Theory
(APT)
The APT (see Ross, 1976) is based on three main propositions:

A factor model can describe assets’ returns.

Idiosyncratic risk can be diversi ed away.

Financial markets are ef cient; thereby resulting no arbitrage opportunities.

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 The Arbitrage Pricing Theory
(APT)
When arbitrage opportunities exist, you take positions to obtain risk-free pro ts.

Inef cient markets: arbitrage-pro t transactions may not immediately drive away
the arbitrage opportunities.

Ef cient markets: arbitrage-pro t transactions would quickly result in changes in

asset prices and the arbitrage opportunities would disappear quickly.

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The APT

Recall a portfolio of risky assets in a single-factor model.

e
The excess return on a portfolio (rP) of n stocks with weights wi is given by
e e
rP = E(rP) + βPF + eP,
n

∑
where βP = wi βi.
i=1
n n
e e
∑ ∑
E(rP) = wiE(ri ) = wi(E(ri) − rf ).
i=1 i=1
n

∑
eP = wiei.
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i=1
The APT

The error term of well-diversi ed APT portfolios would approach zero as the
number of assets in the portfolio increases.

The weightings for all assets include in a portfolio decrease as the number of assets
in the portfolio increases.

A well-diversi ed portfolio: one with each weight small enough that the non-
systematic variance becomes effectively negligible.

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The APT

For a well-diversi ed portfolio of risky assets, the expected value of the error term
(eP) is zero. The excess return on a well-diversi ed portfolio can be given by
e e
rP = E(rP) + βPF,
n

∑
where βP = wi βi.
i=1
n n
e e
∑ ∑
E(rP) = wiE(ri ) = wi(E(ri) − rf ).
i=1 i=1
n

∑
eP = wiei ≅ 0.
i=1 6
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Returns as a Function of the
Systematic Factor

Source: Figure 10.1 from Bovie et al. (2018), page 314

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Returns as a Function of the Systematic
Factor: An Arbitrage Opportunity

The Security
Market Line of
the APT

Source: Figure 10.2 from Bovie et al. (2018), page 316

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An Arbitrage Opportunity

Source: Figure 10.3 from Bovie et al. (2018), page 316

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The APT

Using the well-diversi ed market index as a proxy for the macro factor, we can
rewrite the excess return on a well-diversi ed portfolio as
e e
rP = αP + βPrM = αP + βP(rM − rf ),

where βP refers to the beta against the well-diversi ed market index.

The expected excess return on a well-diversi ed portfolio can be expressed as

e e
E(rP) = βPE(rM) = βP(E(rM) − rf ).

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The APT

APT applies to well diversi ed portfolios and not necessarily to all individual
stocks.

With APT it is possible for some individual stocks to be mispriced (i.e., not lie on
the SML).

APT can be extended to multi-factor models.

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The Multi-Factor APT

As the original APT was built on a single factor, the approach seems to be too
simplistic.

A multi-factor APT model uses more than one factor to improve the quality of the
model.

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 The Multi-Factor APT

Each factor is employed to track a particular source of macroeconomic risk.

Factors should be uncorrelated with other factors.

How to nd the relevant risk factors (and their risk premium)?.

A tradeoff between the improvement in the model and the complexity of the
model.

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Key Differences between the
CAPM and the APT
The CAPM
The CAPM describes equilibrium for all assets.
The CAPM equilibrium is restored by the actions of many small investors.
The model is based on an inherently unobservable “market” portfolio.
The APT
There is no need to use a market portfolio to derive the expected return-beta relationship.
Equilibrium means no arbitrage opportunities.
The APT equilibrium is restored by the actions of a few investors.

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The Multi-Factor CAPM and the
Multi-Factor APT
A multi-factor CAPM will generally get its risk factors from sources of risk that a
broad group of investors consider important.

The APT or the multi-factor APT does not tell us where to obtain sources of risk.

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References

Bodie, Z., Kane, A., & Marcus, A. J. 2023. Investments. 13th ed.: McGraw-Hill
Education.

Elton, E., Gruber, M.J., Brown, S.J., & Goetzman, W. N. 2014. Modern Portfolio
Theory and Investment Analysis. 9th ed.: Wiley.

Fama, E.F., French, K.R. 1992. The cross-section of expected stock returns. Journal of
Finance 47, 427-465.

Fama, E.F., French, K.R. 1993. Common risk factors in the returns on stock and
bonds. Journal of Financial Economics 33, 3–56.

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References

Fama, E.F., French, K.R. 1996. Multifactor explanations of asset pricing anomalies.
Journal of Finance 51, 55-84.

Lintner, J. 1965. The valuation of risk assets and the selection of risky investments
in stock portfolios and capital budgets. Review of Economics and Statistics, 47: 13–37.

Ross, S.A. 1976. The arbitrage theory of capital asset pricing. Journal of Economic
Theory 13, 341-360.

Sharpe, W.F. 1964. Capital asset prices: A theory of market equilibrium under
conditions of risk. Journal of Finance 19, 425-442.

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