Chapter 12
An Alternative View of Risk and Return: The
Arbitrage Pricing Theory
Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure
of total risk.
For well-diversified portfolios, unsystematic
risk is very small.
Consequently, the total risk for a diversified
portfolio is essentially equivalent to the
systematic risk.
12-2
Risk: Systematic and Unsystematic
We can break down the total risk of holding a stock into
two components: systematic risk and unsystematic risk:
2
R R U
Total risk
becomes
R Rmε
where
Nonsystematic Risk:
m is the systematic risk
Systematic Risk: m ε is the unsystemat ic risk
n 12-3
Systematic Risk and Betas
The beta coefficient, , tells us the response of the stock’s return
to a systematic risk.
In the CAPM, measures the responsiveness of a security’s
return to a specific risk factor, the return on the market portfolio.
Cov( Ri , RM )
i
( RM )
2
• We shall now consider other types of systematic risk.
12-4
Systematic Risk and Betas
For example, suppose we have identified three
systematic risks: inflation, GNP growth, and the
dollar-euro spot exchange rate, S($,€).
Our model is:
R Rmε
R R β I FI βGNP FGNP βS FS ε
β I is the inflation beta
βGNP is the GNP beta
βS is the spot exchange rate beta
ε is the unsystemat ic risk 12-5
Systematic Risk and Betas: Example
R R β I F I β G NP FG NP β S FS ε
Suppose we have made the following estimates:
1. I = -2.30
2. GNP = 1.50
3. S = 0.50
Finally, the firm was able to attract a “superstar” CEO,
and this unanticipated development contributes 1% to
the return.
ε 1%
R R 2 . 30 F I 1 . 50 FG NP 0 .50 FS 1 %
12-6
Systematic Risk and Betas: Example
R R 2 . 30 F I 1 . 50 FG NP 0 . 50 FS 1 %
We must decide what surprises took place in the
systematic factors.
If it were the case that the inflation rate was expected
to be 3%, but in fact was 8% during the time
period, then:
FI = Surprise in the inflation rate = actual – expected
= 8% – 3% = 5%
R R 2 . 30 5 % 1 . 50 FG NP 0 . 50 FS 1 %
12-7
Systematic Risk and Betas: Example
R R 2 . 30 5 % 1 . 50 FG NP 0 . 50 FS 1 %
If it were the case that the rate of GNP growth
was expected to be 4%, but in fact was 1%,
then:
FGNP = Surprise in the rate of GNP growth
= actual – expected = 1% – 4% = – 3%
R R 2 . 30 5 % 1 . 50 ( 3 %) 0 . 50 FS 1 %
12-8
Systematic Risk and Betas: Example
R R 2 . 30 5 % 1 . 50 ( 3 %) 0 . 50 FS 1 %
If it were the case that the dollar-euro spot
exchange rate, S($,€), 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 %
12-9
Systematic Risk and Betas: Example
R R 2 . 30 5 % 1 . 50 ( 3 % ) 0 . 50 ( 10 % ) 1 %
Finally, if it were 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 %
12-10
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 has return:
Ri R i β i F ε i
12-11
Relationship Between the Return on
the Common Factor & Excess Return
Excess Ri R i β i F ε i
return
If we assume
that there is no
unsystematic
i risk, then i = 0.
The return on the factor F
12-12
Relationship Between the Return on
the Common Factor & Excess Return
Excess
return
If we assume
Ri R i β i F that there is no
unsystematic
risk, then i = 0.
The return on the factor F
12-13
Relationship Between the Return on
the Common Factor & Excess Return
Excess
return β A 1 .5 β B 1 .0
Different
securities will
β C 0 . 50 have different
betas.
The return on the factor F
12-14
Portfolios and Diversification
We know that the portfolio return is the weighted
average of the returns on the individual assets in the
portfolio:
R P X 1 R1 X 2 R 2 X i R i X N R N
Ri R i β i F ε i
R P X 1 ( R 1 β1 F ε1 ) X 2 ( R 2 β 2 F ε 2 )
X N (R N βN F εN )
R P X 1 R 1 X 1 β1 F X 1ε1 X 2 R 2 X 2 β 2 F X 2 ε 2
X N R N X N βN F X N εN 12-15
Portfolios and Diversification
The return on any portfolio is determined by three sets
of parameters:
1. The weighted 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 R1 X 2 R 2 X N R N
( X 1 β1 X 2 β 2 X N β N ) F
X 1 ε1 X 2 ε 2 X N ε N
In a large portfolio, the third row of this equation
disappears as the unsystematic risk is diversified away. 12-16
Portfolios and Diversification
So the return on a diversified portfolio is
determined by two sets of parameters:
1. The weighted average of expected returns.
2. The weighted average of the betas times the factor
F.
RP X 1 R1 X 2 R 2 X N R N
( X 1 β1 X 2 β 2 X N β N ) F
In a large portfolio, the only source of uncertainty is the
portfolio’s sensitivity to the factor.
12-17
Betas and Expected Returns
R P X 1 R 1 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 βP F 12-18
Relationship Between & 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
12-19
Relationship Between & Expected
Return
Expected return
SML
D
A B
RF
C
R RF β (R P RF )
12-20
Practice Questions
12-21
Practice Questions
12-22