Single Factor Model

The single index model is that all stocks are affected by movements in the stock market. Casual
Observation of share prices reveals that when the market moves up, prices of most shares tend to
increase. When market goes down, the prices of most shares tend to decline. This suggest that
one reason why security returns might be correlated and there is co movement between the
securities is because common response to market changes. This co movement of stocks with
market index may be studied with the help of a simple linear regression analysis taking the
returns on an individual security as the dependent variable (R i) and the return on the market
index (R m) as the independent variable.

The return of an individual security is assumed to depend on the return on market Index. The
return on an Individual Security may be expressed as:

Ri = αi+ βi R m +e i

Where ,
α i = component of security i’ s return that is independent of the market’s performance.
β i = Constant that measures the expected change in R i given change in R
m

R m = Rate of return on market Index.

e i = Error term representing the random or Residual Return
This equation breaks the return on a stock in to two components. one
part due to the market and other part independent of the market.

The β i parameter in the equation , measures how sensitive a stocks return is the return to
market index. It indicates how extensively the return of a security will vary with the changes in
the market return. For example, if the β i of a security is 2 then the return of a
security is expected to increase by 20% when the market returns increases
by 10%.A beta coefficient greater than one would suggest greater
responsiveness on the part of the stock in relation to the market and vice
versa.

The α i parameter indicates what the return of the security would be when the
market return is zero.like a security with an alpha of +3 % would earn 3 % return even when the
market return is zero.
e is the unexpected return resulting from influences not identified by the
i
model. It is referred to as random or residual return. It may take on any value

Multi Index Model

The single index model is an over simplification. It attempts to identify and incorporate these
non market or extra market factors that cause the securities to move together. These extra
market factors are a set of economic factors that accounted for common movement in stock
prices beyond that accounted for by the market index. Fundamental economic variables such as
Real Economic growth , interest rates, exchange rates would have impact in determining security
returns and hence their co movement.

R i = α i + β mR m + β 1 R 1+ β 2 R 2+ β 3 R 3+ ei
This model says that the return of an individual security is a function of four factors – the general
market factor R m and three extra market factors R 1, R 2 , R 3.

α i = component of security i’ s return that is independent of the market’s performance.

β i = Constant that measures the expected change in R i given change in R
m

R m = Rate of return on market Index.

e i = Error term representing the random or Residual Return
This equation breaks the return on a stock in to two components. one
part due to the market and other part independent of the market.
Multi Index Models attempt to identify and Incorporate these non market or
extra market factors that cause securities to move together also into the
model.
Arbitrage Pricing Theory
Arbitrage Pricing Theory is one of the tools used by the investors and portfolio managers.
Arbitrage is the process of earning profit by taking advantage of differential pricing for the same
asset. The process generates riskless profit. APT is founded on the notion that investors are
rewarded for assuming non diversifiable (systematic Risk). Beta is considered as most important
single factor in CAPM that captures the systematic risk of an asset.

In APT there are number of industry specific and macro economic factors that effect the security
returns. Thus a number of factors may measure the systematic risk of an asset.

In the security market, it is of selling security at high price and simultaneous purchase of the
same security at low price..

Assumptions of APT

The investors have homogenous expectations

The investors are risk averse and utility maximisers

Perfect competition prevails in the market and there is no transaction cost.

Arbitrage Portfolio

Acc to APT theory an investor tires to find out the possibility to increase returns from his
portfolio without increasing the funds in the portfolio. He also likes to keep the risk at the same
level. for ex. The investor holds A , B, C securities and he wants to change the proportion of the
securities without the financial commitment. Now the change in the proportion of securities can
be denoted by X a , Xb, Xc. The increase in the investment in security A could be carried out
only if he reduces the proportion of investment either in B and C because it has already stated
that the investor tries to earn more income without increasing the financial commitment.

Concept of Return under APT

The return of an asset is assumed to have two components

Predictable (expected) and unpredictable (uncertain) Return.

Thus Return on asset J will be

E(R j )= R f + UR

Rf is predictable Return

UR is unanticipated return.

The predictable return depends upon the information available to shareholders that has bearing
on the share prices.

The unpredictable return arises from the future information. This information may be firm
specific and market related (macro economic factor). The firm specific factors are special to the
firm and affect only the firm. The market related factors affect all the firms. Thus uncertain
return may come from the specific information and the market related information.

E(Rj)= R f + UR s + UR m

UR s = is the unexpected component of return arising from the specific factors related to the
firm.

UR m is that component of the unexpected return that arises from the economy wide market
related factors.

Concept of risk under APT

The risk arising from the firm specific factors is diversifiable. It is unsystematic risk. The risk
arising from the market related factors can not be diversified. This represents the systematic risk.
In APT assumes market risk can be caused by economic factors such as change in GDP ,
inflation , interest rates and these factors could affect firms differently. for ex, different firms
may feel the impact of inflation differently. Therefore multiple factors may be responsible for the
expected return on the share of a firm. Therefore under APT the sensitivity of assets return toe
ach factor is estimated. For each firm there will be as many betas as the number of factors .

E(R i )= R f + β 1f 1 + β 2 f 2+ β 3f3+ ------β n f n + UR s

f represents the surprise in factors.

Steps in calculating Expected Return under APT

1. Searching for the factors that affect the assets return

2. estimation of risk premium for each factor: it is the compensation over and above the risk free rate of return that

investors require for the risk contributed by the factor,.

 3. estimation of factor beta : sensitivity of the assets return to the changes in the factor

Covariance

Co movement between the returns of securities are measured by covariance. Covariance reflects
the degree to which the returns of two securities vary or change together.

The covariance means that the returns of the two securities move in same direction where as –ve
covariance implies that the returns of the two securities move in opposite direction.