Arbitrage Pricing Theory

and Multifactor Models of

Risk and Return
CHAPTER 6
DR. LOUKIA EVRIPIDOU

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Overview
Arbitrage is the exploitation of security mispricing in such a way that
risk-free profits can be earned.
• Most basic principle of capital market theory is that well-
functioning security markets rule out arbitrage opportunities.
Generalization of the security market line of the C A P M to gain
richer insight into the risk–return relationship.
• Arbitrage pricing theory (A P T).

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 Multifactor Models: A Preview
Stock price variability arises from two primary sources:
Market (Systematic) Risk – This reflects broad economic and macroeconomic factors that impact all
securities. Events such as interest rate changes, inflation fluctuations, GDP growth, and geopolitical events
contribute to systematic risk. Since this risk is inherent to the entire market, it cannot be eliminated
through diversification.
Firm-Specific (Idiosyncratic) Risk – This is unique to individual companies and can result from factors
such as management decisions, competitive positioning, product innovation, or regulatory changes. Unlike
systematic risk, firm-specific risk can be reduced through portfolio diversification.
While traditional models like CAPM focus solely on market risk (beta), real-world stock returns are also
influenced by additional extra-market risk factors, including:
•Inflation – Rising inflation erodes purchasing power and can impact corporate profitability.
•Interest Rates – Changes in interest rates influence discount rates, borrowing costs, and investor risk
preferences.
•Volatility – Market uncertainty and fluctuations affect risk premiums and investor sentiment.
•Liquidity and Credit Conditions – Access to capital and financial stability play a role in stock pricing.
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Factor Models of Security Returns (1)

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 Factor Models of Security Returns (2)
•Multifactor models extend beyond the Capital Asset Pricing Model (CAPM) by
assuming that returns respond to multiple systematic risk factors, rather than a single
market risk factor.
•These models help investors identify and manage exposure to various risks more
effectively.
Multifactor models posit that returns respond to several systematic risk factors, as well
as firm-specific influences.
•They enhance risk management, portfolio diversification, and asset pricing accuracy.
•By incorporating extra-market risks, multifactor models offer a realistic and data-
driven approach to understanding return behaviour

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MFM - Improved Risk Management
Multifactor models allow investors to identify specific risk exposures beyond
market-wide fluctuations. This helps in:
•Hedging Risks – Investors can hedge against inflation, interest rate changes, or
sector-specific risks by taking counterbalancing positions.
•Stress Testing Portfolios – Evaluating how portfolios respond to different risk
factors helps in managing potential drawdowns.
•Asset Allocation Decisions – Investors can tilt portfolios towards assets that
have lower exposure to undesired risk factors.

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MFM-Enhanced Portfolio Diversification
•Since multifactor models identify multiple sources of systematic risk,
they allow investors to spread investments across uncorrelated
factors, improving diversification.
•For example, the Fama-French Three-Factor Model considers size
(SMB) and value (HML) factors alongside market risk, helping
investors reduce concentration in a single factor
•By diversifying across factors such as momentum, quality, or
volatility, investors can reduce portfolio risk while maintaining
expected returns.

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MFM- More Accurate Asset Pricing
•Traditional models like CAPM assume a single market factor drives
returns, which oversimplifies real-world pricing. Multifactor models
add additional macro and firm-level factors to improve predictive
power.
•The Arbitrage Pricing Theory (APT) provides a flexible framework
where returns are driven by multiple economic factors, allowing for
more precise valuation of assets.
•Incorporating real economic drivers such as interest rates, inflation,
and industrial production helps better explain stock return
variations.

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 Arbitrage Pricing Theory
•The Arbitrage Pricing Theory (APT), developed by Stephen Ross in 1976, is a multi-factor
asset pricing model that explains security returns based on their sensitivity to multiple risk
factors.
• Unlike the Capital Asset Pricing Model (CAPM), which relies on a single market risk factor,
APT allows for multiple sources of systematic risk, making it more flexible and realistic.
•It predicts a Security Market Line (SML) linking expected returns to risk.
•While CAPM is easier to apply, APT provides a more nuanced and comprehensive approach
to asset pricing.
•APT assumes that in an equilibrium state, no investor can earn risk-free profits from
mispricings, and all assets are priced according to their systematic risk exposures
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 Key Propositions of APT
1. Asset Returns Are Influenced by Multiple Systematic Factors
• Instead of a single market factor (as in CAPM), APT assumes that multiple
macroeconomic factors drive asset returns, such as inflation, interest rates,
GDP growth, and volatility.
2. No Arbitrage Condition Ensures Fair Pricing
• If two portfolios have the same risk exposure but different expected returns,
arbitrageurs will exploit price differences until prices adjust and no risk-free
profit remains.
3. Linear Relationship Between Expected Returns and Risk Factors
• Expected returns are a linear function of an asset’s sensitivity (betas) to
multiple risk factors, each with its own risk premium.

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 Arbitrage, Risk Arbitrage, and
Equilibrium
1. Arbitrage : Arbitrage refers to the practice of exploiting price differences of an asset in different markets to earn a risk-
free profit. In an efficient market, arbitrage opportunities should not persist for long, as traders quickly exploit them,
bringing prices back into equilibrium. Examples include:
• Spatial arbitrage (buying an asset in one market and selling it in another at a higher price).
• Temporal arbitrage (taking advantage of price changes over time).
2. Risk Arbitrage : Involves taking positions in securities where the profit is not guaranteed but highly probable based on
expected future events. Common examples include:
• Merger arbitrage: Investors buy the stock of a target company and short the stock of the acquiring company, profiting from price
movements after the merger announcement.
• Event-driven arbitrage: Trading based on corporate events such as earnings reports, regulatory approvals, or legal rulings.
3. Equilibrium Equilibrium in financial markets occurs when all available information is fully reflected in asset prices,
leaving no arbitrage opportunities. APT suggests that multiple risk factors influence asset prices, and when correctly
priced, arbitrageurs ensure that securities align with their expected risk-return profile.

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 Law of One Price - LOOP
LOOP states that identical assets should have the same price in different markets when expressed in a common currency,
assuming no transaction costs or trade barriers. This principle is fundamental to efficient markets and is enforced by
arbitrageurs.
How Arbitrage Enforces the Law of One Price
• When arbitrageurs detect a price discrepancy for the same asset across markets, they buy where the price is low and sell
where the price is high.
• This bidding up the lower price and pushing down the higher price continues until the price difference disappears,
restoring equilibrium.
Examples of LOOP in Action
1. Currency Exchange Markets (Forex Arbitrage): If the exchange rate of EUR/USD differs between two currency markets,
traders can buy euros in the cheaper market and sell in the more expensive one, eliminating price differences.
2. Stock Listings in Multiple Exchanges (Dual-Listed Stocks): A stock listed on both the NYSE and the LSE should trade at
approximately the same price. If not, arbitrageurs profit from the difference until prices converge.

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Well-Diversified Portfolios

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 The red points are the monthly returns over a
five-year period of a single stock. The blue points
are for diversified stock mutual fund (Vanguard’s
Growth Income Fund). During the period both
the stock and the fund had virtually identical
betas. But their non-systymatic risk differed
considerably. The scatter of Intel’s returns falls
considerably further from the regression line
than the mutual fund’s for which diversification
has eliminated most residual risk

Figure 10.1 Scatter diagram for a single stock (Intel) and a diversified mutual fund (Vanguard Growth and Income). The fund
exhibits much smaller scatter around the regression line.

Access the text alternative for slide images.

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 Figure 10.2 Excess returns as a function
of the systematic factor: Panel A, Well-
diversified portfolio A; Panel B, Single
stock (S).

The solid line in Figure 10.2, panel A plots the excess return of a well-diversified portfolio A with E (RA)= 10% and bA=1 for
various realizations of the systematic factor. The expected return of portfolio A is 10%; this is where the solid line crosses
the vertical axis. At this point the systematic factor is zero, implying no macro surprises. If the macro factor is positive,
the portfolio’s return exceeds its expected value; if it is negative, the portfolio’s return falls short of its mean. Compare
panel A in Figure 10.2 with panel B, which is a similar graph for a single stock (S) with bS=1. The undiversified stock is
subject to nonsystematic risk, which is seen in a scatter of points around the line. The well-diversified portfolio’s return,
in contrast, is determined completely by the systematic factor.
Access the text alternative for slide images.

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The SML of the APT
All well-diversified portfolio with the same beta must have the same expected
return.
Generally, for any well-diversified P, the expected excess return must be:

E  R p   β p E  RM 

Risk premium on portfolio P is the product of its beta and the risk premium of the
market index.
• SML of the CAPM must also apply to well-diversified portfolios.

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 Figure 10.3 plots the returns on two such portfolios, A and
B, both with betas of 1, but with differing expected returns:
E( rA ) =10% and E (rB)= 8%.
Could portfolios A and B coexist with the return pattern
depicted?
Clearly not: No matter what the systematic factor turns out
to be, portfolio A outperforms portfolio B, leading to an
arbitrage opportunity.

Figure 10.3 Returns as a Function of the Systematic

Factor: An Arbitrage Opportunity

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Figure 10.4 An Arbitrage Opportunity

Their risk premiums must be proportional to beta.

Suppose that the Rf =4% and that a well-diversified
portfolio, C, with a b=0.5, has an E(RC) =6%.
Portfolio C plots below the line from the risk-free asset
to portfolio A.
Consider, a new portfolio, D, composed of half of
portfolio A and half of the risk-free asset. Portfolio D ’s
beta will be (.5* 0 + .5 *1) = 0.5, and its expected return
will be (.5 * 4+ .5* 10)= 7%. Now portfolio D has an
equal beta but a greater expected return than portfolio
C. We know that this constitutes an arbitrage
opportunity.
We conclude that, to preclude arbitrage opportunities,
the expected return on all well-diversified portfolios
must lie on the straight line from the risk-free asset in
Figure 10.4 .

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 APT vs CAPM
• APT is an extension of CAPM in the sense that both models aim to
explain asset returns based on their risk exposure, but APT improves on
CAPM by relaxing the assumption of a single risk factor and
incorporating multiple factors that affect returns.
• APT introduces arbitrage as a key concept in asset pricing, allowing it to
address market inefficiencies that CAPM overlooks.
• While CAPM focuses on the relationship between an asset and the
market portfolio, APT provides a more comprehensive framework by
considering various macroeconomic factors that influence asset
returns.
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Similarities Between CAPM and APT
Feature CAPM & APT
Risk-Return
Both establish a linear relationship between risk and return.
Relationship
Both assume that security prices reflect all available
Market Efficiency information, eliminating arbitrage opportunities in
equilibrium.
Focus on Systematic Both emphasize systematic (non-diversifiable) risk as the
Risk primary determinant of expected returns.
Portfolio-Based Both models apply to well-diversified portfolios and use
Approach factor-based risk assessments.

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 Difference APT & CAPM
Feature APT CAPM
Multiple factors (e.g., interest rates, inflation,
Risk Factors Single factor (market risk—beta).
GDP growth).
Fewer assumptions; does not require a market Strong assumptions (e.g., market efficiency, rational
Assumptions
portfolio. investors, mean-variance optimization).
Return Expected return depends on multiple Expected return is determined by a security’s sensitivity to
Determination systematic risk factors and their sensitivities. market risk (beta).
Based on arbitrage opportunities eliminating
Arbitrage Concept Does not explicitly rely on arbitrage.
mispricing.
Model
More complex due to multiple factors. Simpler, widely used in financial analysis.
Complexity
Used in empirical asset pricing, risk Commonly applied in investment decisions, asset
Application
management, and portfolio analysis. valuation, and portfolio management.
More flexible as it allows for different risk More rigid due to reliance on the single-factor market
Flexibility
factors based on market conditions. model.
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A Multifactor APT
•Multifactor APT is an extension of APT that allows for more detailed
modeling of asset returns by incorporating multiple sources of
systematic risk, providing a more comprehensive understanding of
risk and return dynamics.
•The generalization of the APT to accommodate these multiple
sources of risk is done in a manner similar to the multifactor CAPM

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 Key Concepts of Multifactor APT (1)
1. Multiple Factors: In Multifactor APT, the returns of an asset are explained by more than
one factor, such as inflation, interest rates, GDP growth, exchange rates, and others. Each
of these factors has a corresponding factor beta, which measures how sensitive the asset
is to that specific factor.
2. Factor Sensitivities (Betas): Just like CAPM has a single beta coefficient representing an
asset's sensitivity to market returns, Multifactor APT uses multiple betas, each
corresponding to a specific factor. These betas are used to estimate how sensitive an
asset's return is to each of the risk factors.
3. Arbitrage: Arbitrage opportunities arise when an asset's price deviates from its fair
value based on its exposure to multiple factors. In a well-functioning market, arbitrageurs
will exploit these mispricings, forcing asset prices back to equilibrium by buying
undervalued assets and selling overvalued ones.
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 Key Concepts of Multifactor APT (2)
4. Factor Model Equation: The general formula for a multifactor model in APT is:

Ri = Rf + β1 F1 + β2 F2 + ... + βn Fn + εi
Where:
- Ri = Expected return on the asset i
- Rf = Risk-free rate
- β1, β2, ... , βn = Sensitivities (betas) to factors F1, F2, ... , Fn
- F1, F2, ... , Fn = Systematic risk factors (e.g., inflation, interest rates, etc.)
- εi = Idiosyncratic (firm-specific) risk or noise
5. No Arbitrage Condition: Just like traditional APT, multifactor APT relies on the principle of
no-arbitrage. If prices deviate from what is expected given the exposures to the various
factors, arbitrageurs will exploit these opportunities until prices adjust to their correct
levels.

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 Advantages of Multifactor APT
- Greater Flexibility: Unlike CAPM, which relies solely on the market factor to
explain returns, Multifactor APT allows for a more flexible and realistic model by
considering several factors that could influence asset prices.

- More Comprehensive Risk Analysis: By incorporating multiple risk factors (such

as interest rates, inflation, and GDP growth), Multifactor APT provides a more
comprehensive view of the risks that affect an asset's return, making it a more
robust tool for understanding and managing risk.

- Practical for Real-World Applications: Multifactor APT can be used to analyze

how different macroeconomic and market forces influence the prices of assets,
making it useful for portfolio management, risk analysis, and investment
strategies.
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Disadvantages of Multifactor APT
- Complexity: The model becomes more complex as more factors are
added, which may lead to difficulties in identifying and measuring
the correct factors and estimating their respective betas accurately.

- Model Specification Risk: Selecting the wrong factors to include in

the model can result in inaccurate predictions. Unlike CAPM, where
the market factor is well understood, choosing the right factors in
Multifactor APT requires more expertise and research.

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 Aspect APT Multifactor APT
APT is a single-factor model where expected returns are
Multifactor APT extends APT by considering multiple
Basic Concept determined by exposure to one or more systematic risk
systematic risk factors that affect asset returns.
factors.
Multifactor APT incorporates multiple factors (e.g.,
APT considers a single factor, often macroeconomic in
Risk Factors inflation, interest rates, GDP growth, oil prices, etc.) to
nature (e.g., inflation, interest rates).
explain asset returns.
Focuses on multiple risk factors, allowing a more detailed
Focuses on the influence of one risk factor (e.g., market-
Focus explanation of returns based on different economic
wide factor) on the return of an asset.
variables.
More complex, as it considers multiple factors, which
Complexity Simpler model, as it involves fewer factors.
provides a more nuanced view of risk and return.

Used for analyzing assets with respect to one dominant Applied in situations where asset returns are influenced by
Application
risk factor. various macroeconomic and firm-specific variables.
The model assumes a risk premium is tied to a single Risk premiums are associated with multiple factors that
Risk Premium
factor (e.g., market risk). impact the asset’s returns.
More flexible as it can accommodate a broader range of
Flexibility Less flexible as it only focuses on a single risk factor. risk factors, making it suitable for diverse financial
scenarios.
The traditional APT assumes that asset prices are Multifactor APT relaxes this assumption and incorporates
Theoretical
influenced by one fundamental factor that governs the multiple variables to account for asset price fluctuations
Foundation 30
market. CFS 563
more accurately.
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 Fama-French (FF) Three-Factor Model (1)
The Fama-French Three-Factor Model is an asset pricing model developed in the early 1990s. It
expands on the traditional CAPM, by adding two additional factors: size and value. The model is
used to explain stock returns more accurately by accounting for other risk factors that CAPM
overlooks. The three factors in the Fama-French Three-Factor Model are:
Market Risk Premium (MKT): This is the excess return of the market portfolio over the risk-free
rate. It's the same as the factor used in CAPM, representing the systematic risk of the overall
market.
Size (SMB - Small Minus Big): This factor reflects the historical outperformance of small-cap stocks
over large-cap stocks. SMB represents the difference in returns between a portfolio of small stocks
(small market capitalization) and a portfolio of large stocks (large market capitalization).
Value (HML - High Minus Low): This factor captures the historical outperformance of value stocks
(those with high book-to-market ratios) over growth stocks (those with low book-to-market ratios).
HML is the difference between the returns of value stocks and growth stocks.
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 Fama-French (FF) Three-Factor Model (2)
FF is an approach to identify the most likely sources of systematic risk, in which case it uses firm
characteristics that seem on empirical grounds to proxy for exposure to systematic risk.

Rit  αi  βiM RMt  βiSMB SMBt  β iHML HMLt  eit

S M B = Small minus big (the return of a portfolio of small stocks in excess of the return
on a portfolio of large stocks)
H M L = High minus low (the return of a portfolio of stocks with a high book-to-market
ratio in excess of the return on a portfolio of stocks with a low book-to-market ratio)

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 Key Insights of the Fama-French Three-
Factor Model
•It shows that stock returns are influenced not only by market risk but also
by the size and value characteristics of the stocks.
•Small-cap stocks and value stocks tend to offer higher returns, but they also
carry different types of risks compared to large-cap and growth stocks.
•It provides a more comprehensive explanation of stock returns compared
to the CAPM, especially for portfolios that include small-cap or value stocks.
•The Fama-French Three-Factor Model (FF3) is widely used in finance and
investment analysis, particularly in asset pricing, portfolio management,
and risk assessment.

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 Smart Beta Investing
Smart beta is an alternative investment strategy that applies systematic, rule-based
approaches to portfolio construction rather than purely market capitalization weighting. It
seeks to capture factors that have historically provided excess returns.
Key Characteristics of Smart Beta:
Rules-based approach: Investments are selected based on predefined factors rather than traditional
active management.
Factor exposure: Smart beta strategies tilt towards factors like value, momentum, size, and volatility.
Risk-adjusted returns: They aim to improve returns while managing risk compared to traditional
indexes.
Lower cost than active funds: Typically cheaper than actively managed funds but more complex
than traditional index funds.
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Types of Smart Beta Strategies
1. Fundamental Weighting: Stocks are weighted based on financial metrics
(e.g., revenue, earnings, dividends) rather than market capitalization.
2. Equal Weighting: Each stock in an index is given the same weight, reducing
the dominance of large-cap stocks.
3. Factor-Based Strategies: Portfolios are constructed to maximize exposure to
specific factors (e.g., value, momentum, quality).
4. Minimum Volatility: Stocks are selected to minimize overall portfolio
volatility.
5. Dividend Yield-Based Strategies: Stocks with high and sustainable dividend
yields are prioritized.

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Smart Betas and Multifactor Models
Smart-beta ETFs
• Analogous to index ETFs, but instead provide exposure to specific characteristics.
• Fama-French five-factor model: Size (SMB), Value (HML), Operating Profitability (RMW), and
Investment (CMA) in addition to Market.
• Momentum: Portfolio return that buys recent well-performing stocks and sells poorly
performing ones.
• Other Factors: Volatility, as measured by the standard deviation of stock returns; Liquidity; and
Dividend Yield.

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 Comparing Smart Beta and Multifactor
Models
Aspect Smart Beta Multifactor Models
A systematic, rules-based A theoretical framework
Definition strategy that tilts towards explaining stock returns using
specific factors multiple risk factors
Used in ETFs and index funds for Used in asset pricing and risk
Application
passive investing management
Relatively simple and rules- More sophisticated, requiring
Complexity
based statistical modeling
Factor-based ETFs (e.g., value Fama-French factor models,
Example Products
ETFs, low-volatility ETFs) hedge funds using factor investing

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