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CHAPTER ARBITRAGE PRICING THEORY

The theory was originally developed in 1976 by Stephen A. Ross to overcome the shortcomings of CAPM. It is a novel and adopted a different approach for determining the asset price. CAPM assumes mean-variance framework. However, APT is more general in that asset prices are influenced by factors beyond mean and variance. According to APT return on any stock is linearly related to a set of factors. These factors are risk factors. APT does not specify these factors. The objective of security analysis is to identify the factors in the economy and the sensitivities of security returns to movements on these factors. And formal statement of relationship called factor model of security return is stated. APT equation is as follows :

Ri = ai + bi1 I1 + bi2 I2 + .+ bij Ij + ei


Ri = ai = Ij = bij = ei = Return on stock I Expected return on stock I if all factors have a value of zero Value of jth factors which influences the return on the stock Sensitivity of stock Is return to the jth factors Random error term which has a mean of mean of zero and variance of 2ei

Equilibrium Risk-return relationship of APT :

E(Ri) = 0 + 1 bi1 + 2 bi2 + bij j


0 = Risk free return 1 = Risk premium for the type of the risk (i.e. value of the factor) Important points Developed in the year 1976 by Stephen A.Ross It is also equilibrium pricing model like CAPM CAPM is a Uni-dimensional and APT is multidimensional model CAPM follows means variance framework, APT follows factors beyond meansvariance framework The required rate is influenced by more than one factor. Return on any stock is linearly related to a set of factors (systematic factors) Expected return on a stock is dependent on how investment reacts to a set of individual macro economic factors and risk premium associated with each of those factors. Degree of reaction is measured by the beta. Macro Economic factors are : Changes in level of production inflation rate real interest rate personal consumption level of money supply 1

default risk premium shape of yield curve etc.

EXERCISE PROBLEMS 1. Consider the following information relating to a stock X and calculate its expected rate of return. 1 1 = 2.0 = 1.4 2 2 = 1.50 = 1.8 3 3 = 0.80 = 0.6 Risk free rate is assumed to be 6% (Avadhani-608) Solution : E(Ri) = 0 + 1 bi1 + 2 bi2 + 3 bi3
= 6 + 2 x 1.4 + 1.5 x 1.8 + 0.80 x 0.60 = 11.98%

2. What is the equilibrium rate of return in the following stocks if two factor model is applicable as given below. E(R) = 6% + 5% i1 + 7% i2 and X 1.5 0.8 Stocks Y 0.5 1.8 Z 1.9 -0.8

i1 i2 (Avadhani-608) Solution :

E (RX) = 6 + 5 x 1.5 + 7 x 0.80 = 19.10% E (RY) = 6 + 5 x 0.5 + 7 x 1.80 = 21.10% E (RZ) = 6 + 5 x 1.9 + 7 x -0.80 = 9.90% 3. Consider the reaction co-efficient and market price of the stock A and B. Factor 1 2 3 Market Price () 0.10 0.08 -0.05 A 0.6 0.4 1.5 B 0.9 0.7 0.5

Calculate expected rate of return if equal amount of the fund is invested in each of the security. Risk free rate is assumed to be 7%. (Avadhani-2-614) Solution : E (RA) = 0.07 + 0.10 (0.60) + 0.08 (0.40) 0.05 (1.5) 0.07 + 0.06 + 0.032 0.075 = 8.7% E (RB) = 0.07 + 0.10 (0.9) + 0.08 (0.7) 0.05 (05) 2

= 0.07 + 0.09+ 0.056 0.025 = 19.1% E (RP) = 0.05 x 8.7 + 0.5 x 19.1 = 4.35 + 9.55 = 13.90% 4. The return in a stock of modern industries is related to two factors. Sensitivity factors of the stock is 1.5 and 0.5 for the factor 1 and 2 respectively. And risk premium is factor-1 = 7% and factor-2 = 4%. What is the expected rate of return of the stock if risk free rate is 8%. (Avadhani-1-614) Solution : E(Ri) = 0 + 1 bi1 + 2 bi2 = 8 + 7 x 1.5 + 4 x 0.5 = 8 + 10.50 + 2 = 20.5% 5. What are the expected earningsyield and book price factor values for the stocks A and B in respect of which the following information is supplied ? Earnings-Yield Book Price Zero factor Ri (in %) (Bhalla-5-725) Solution : Computation of Expected rate of returns of the two stocks A and B E (RA) : 20 = 8 + 15 F1 + 3 F2 E (RB 16 = 6 + 10 F1 + 1.5 F2 20 = 8 + 15 F1 + 3 F2 16 = 6 + 10 F1 + 1.5 F2 12 = 15 F1 + 3 F2 10 = 10 F1 + 1.5 F2 24 = 30 F1 + 6 F2 30 = 30 F1 + 4.5 F2
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Stock - A 15% 3 8% 20

Stock - B 10% 1.5 6% 16

(Multiplied by 2) (Multiplied by 3)

-6 =

1.5 F2

F2 = - 6 / 1.5 = - 4 Using any one Equation 24 = 30 F1 + 6 F2 24 = 30 F1+ 6 x 4 24 = 30 F1- 24 F1 = 24 + 24 = 48/30 = 1.60 3

30 6. Consider the following information relating to three portfolios and give the equation of the plan in Ri, i1 and i2 space defined by these portfolios. Portfolio I II III (Bhalla-1-720) Solution : Equation of risk-return plan is developed using returns and sensitivity factors in the following three portfolios . Portfolio I : 18 = 0 + 1.0 1 + 1.0 2 Portfolio II : 15 = 0 + 0.8 1 + 0.5 2 Portfolio III : 16 = 0 + 0.6 1 + 0.8 2 Subtracting II equation from Ist equation 18 = 0 + 1.0 1 + 1.0 2 15 = 0 + 0.8 1 + 0.5 2
--------------------------------------------------___________________________

Ri 18 15 16

i1 1.0 0.8 0.60

i2 1.0 0.5 0.8

Equation - I Equation - II Equation - III

3=

+ 0.2 1 + 0.5 2

Equation - IV

Subtracting III equation from IInd equation 15 = 0 + 0.8 1 + 0.5 2 16 = 0 + 0.6 1 + 0.8 2
-------------------------------------------_____________________________

-1 =

+ 0.2 1 - 0.3 2

Equation - V

3 = + 0.2 1 + 0.5 2 -1 = + 0.2 1 - 0.3 2 + + _____________________ 4= 0.8 2 2 = 4 / 0.8 = 5 Taking IVth Equation 3 = + 0.2 1 + 0.5 2 3 = + 0.2 1 + 0.5 x 5 (Substituting 2 value) 3 = + 0.2 1 + 2.50 1 = 3 2.50 / 0.20 = 0.50/0.20 = 2.50 Taking Ist Equation 18 = 0 + 1.0 1 + 1.0 2 18 = 0 + 2.5 + 5 (substituting the values of 1and 2) 0 = 18 7.50 = 10.50 Hence, the equation of the plan describing equilibrium risk-return space can be Ri = 10.50 + 2.5 bi1 + 5 bi2 4

7. Consider the following portfolios and determine how much arbitrage profit can be made. Portfolios Ri (in %) P-I 16.0 P-II 14.0 P-III 16.5 i1 0.4 0.9 0.8 i2 0.8 0.6 0.9

Equation of the plan describing equilibrium risk-return is Ei = 7 + 4 bi1 + 7bi2 (Bhalla-2-721) Solution : _ Using risk-return relationship Ri = 7 + 4 bi1 + 7bi2, An equivalent portfolio can be constructed for the portfolios as follows : _ For Portfolio-I : Ri = 7 + 4 x 0.40 + 7 x 0.80 = 7 + 1.60 + 5.60 = 14.20 Since the expected return is more than equilibrium rate (i.e. 16>14.2) portfolio-I is undervalued. A risk less, costless arbitrage profit can be made by buying portfolio-I and selling an equivalent amount in other portfolios. _ For Portfolio-II : Ri = 7 + 4 x 0.90 + 7 x 0.60 = 7 + 3.60 + 4.20 = 14.80 Portfolio-II is overpriced. Therefore, the portfolio-II should be sold and the equivalent portfolio should be bought. _ For Portfolio-III : Ri = 7 + 4 x 0.80 + 7 x 0.90 = 7 + 3.20 + 6.30 = 16.50 Since the equilibrium rate is exactly the same as yield of portfolio-III, no arbitrage opportunities exist for the portfolio. 8. Consider the following information relating to three well diversified portfolios. Portfolio 1 2 3 Factor sensitivity 0.60 1.00 1.60 Expected return (in %) 13.40 14.00 22.40

The expected value of the factor is 9% and one-factor model of the form is Ri = 8% + bi F + ei a. Find whether portfolios expected return is in line with the factor model relationship. b. If it is not in line with the factor model, construct a portfolio of the other two portfolios that has the same factor sensitivity as the out of line portfolio. c. Calculate expected return of the newly constructed portfolio. (Bhalla-7-725) 5

Solution : Computation of Equilibrium Return on the Portfolio (Using one factor model) Ri 8 + biF + ei (ei = 0 zero non factor risk) For Portfolio-1 For Portfolio-2 For Portfolio-3 : R1 = 8 + 0.60 x 9 : R2 = 8 + 1.0 x 9 : R3 = 8 + 1.60 x 9 = 13.40 = 17.00 = 22.40

Second portfolios expected return is out of line with the factor model relationship. Because required return in factor model is greater than the actual expected return (i.e. 17 > 14) Constructing a combination of other two portfolios that has the same factor sensitivity as the out of line portfolio (i.e. 1) X1 x b1 + X3 x b3 = 1 (Factor sensitivity of 2nd portfolio) X1 x 0.60 + X3 x 1.60 = 1 We know that X1 + X3 = 1 Then X3 = 1- X1 0.60 X1 + (1 - X1) x 1.60 = 1 0.60 X1 + 1.60 1.60 X1 = 1 X1 = 0.60 and X3 = 1 0.60 = 0.40 Expected return of the combined portfolio is Rp = 0.60 x 13.40 + 0.40 x 22.40 = 8.04 + 8.96 = 17.0 Investors can create arbitrage portfolio by short selling second portfolio and buying to the extent of 60% in the first and 40% in the third portfolio. 9. Consider that

2m = 529 ; A = 0.80

B = 1.10 covariance(F, Rm) = 300

and find i. beta coefficients of securities X and Y ii. Equilibrium rate of return on both the securities assuming riskfree rate 7% and expected return on the market portfolio 12%. (Bhalla-8-726) Solution : When CAPM holds and returns are generated by one factor model beta of a security is calculated as follows : i = Cov(F, Rm) bA 2m For Security-X : X = 300 / 529 x 0.80 = 0.45 For Security-Y : Y = 300 / 529 x 1.10 = 0.62 Calculation of Expected Equilibrium Return 6

(Using SML equation) _ Ri = Rf +i (Rm Rf) For Security-X : _ RX = 7 + 0.45 (12 7) = 7 + 2.25 = 9.25 For Security-Y : _ RY = 7 + 0.62 (12 7) = 7 + 3.1 = 10.1 10. Mr. Nagaraj owns a portfolio with the following characteristics : characteristic Factor-1 sensitivity Factor-2 sensitivity Non factor risk Security - A 1.4 1.9 25 Security - B 0.4 2.0 20 S.D. 20 22

The sensitivity factors have a covariance of 400. Calculate the standard deviations of securities A and B and covariance between them. Bhalla-6-725) Solution : On the basis of two factor model, the variance of each security is calculated as follows : i2 = bi12 f12 + bi22 f22 + 2 bi1 bi2 + Cov.(f1,f2) + ei2 For Security-A : A2 = (1.4)2 (20)2 + (1.9)2(22)2 + 2 x 1.4 x 1.9 x 400 + 25 = 1.96 x 400 + 3.61 x 484 + 2128 + 25 = 784 + 1747.24 + 2128 + 25 = 4,684.24 ________ A = 4,684.24 = 68.44 For Security-B : B2 = (0.4)2 (20)2 + (2)2(22)2 + 2 x 0.4 x 2 x 400 + 20 = 0.16 x 400 + 4 x 484 + 640 + 20 = 64 + 1,936 + 640 + 20 = 2,660 ____ B = 2,660 = 51.57 The Covariance between the two securities in a two factor model is.. AB = bA1 bB1F12 bA2 bB2F22 + (bA1 bB2 + bA2 bB1) Cov.(F1,F2) [(1.4) (0.4) (20)2] + [(1.9) (2) (22)2] + [(1.4 x 2) + (1.9 x 0.40)] x 400 = 224 + 1,839.2 + [2.8 + 0.76] x 400 7

= 224 + 1,839.2 + 1,424 = 2,487.2 11. Given the following data and that One-factor APM is E(Ri) = 6 + 8 (Beta, 1), show the arbitrage opportunities, if any, that can be exploited. Portfolio Return (in %) A 14 B 16 MBA-III SEM. (BU) - Jan/Feb 2006 Solution : _ RA = 6 + 8 x 1 = 14 _ RB = 6 + 8 x 1 = 14 For Portfolio-A : No arbitrage opportunities exist. Because required rate is exactly equal to the expected return (i.e. 14 = 14) and For Portfolio-B : Arbitrage opportunities exist. Because, expected return is more than required rate (i.e. 16>14). -- 0 -Beta 1.0 1.0

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