Empirical Validation of APT

Lecture 12
27 November 2010
APT: a solution to CAPM shortcomings

z Actual SML is flatted z Factors other than β

than predicted by CAPM influence stock returns:
– Size of the firm (can be
measured by market
capitalization)
– Firm’s perspectives
(can be measured by
book-to-market ratio)
– Momentum (average
stock’s return over the
past six months)
APT: a reminder

z Factor model + absence of arbitrage = APT

z Returns are determined by the sensitivity to a
common set of factors
z The expected return of a security is determined by
the following equation:

E (Ri ) = R f + β 1i λ1 + β 2i λ 2 + ... + β ki λ k
– Where λk = E(RPk) – Rf (risk premium of kth
factor)
Estimating the factors

z Factor analysis
– A statistical procedure aimed at finding factor-
replicating portfolios
z Using macroeconomic variables to generate
factors
– Macro variables are proxies for the factors
z Using characteristic-sorted portfolios to
estimate factors
– Portfolios of securities with some common
characteristic are proxies for the factors
Factor analysis: intuition

z Consider 2 stocks whose returns follow a one-

factor model:
– R1 = a1 + b1F + ε1
– R2 = a2 + b2F + ε2
z From historical data, we can obtain their
variances, and covariance between returns
– (σ1)2, (σ2)2, σ12
z Therefore, we can find the factor properties,
and the sensitivities of the two stock’s returns
– b1, b2, (σF)2
Factor analysis: intuition

z Once we’ve found the sensitivities of individual

securities to the risk factor, we can construct a
factor-replicating portfolio RP1
– RP1 = A + F
– Factor risk-premium = λ1 = E(RP1) – Rf = A – Rf
z The same logic can be applies to a sample of
N securities whose returns are described by a
(N-1) factor model
Factor analysis: pros and cons

z Advantages:
– RPs found in the process of factor analysis provide
the best possible explanation of the covariance
between the stocks’ returns estimated from historical
data
z Disadvantages:
– Assumes covariances do not change over time
– Doesn’t name the economic variables to which
factors are linked
Factor analysis: empirical findings

z Roll & Ross (1980) tried to establish the # of factors

z Were forced to estimate factors on small number of
stocks
– 42 groups
– 30securities each
z Results:
– In 88.1% of the groups there was at least 1 factor with non-zero
risk premium
– In 57.1% - at least 2 factors
– In 33% - at least 3
z Conclusions:
– At least 3 factors are important for APT, but probably no more
than 4
Macroeconomic variables approach

z Identify the complete set of possible factor affecting the

returns: changes (unanticipated) in
– Unemployment
– Inflation
– Interest rates spreads
– Oil prices
– Credit spreads
– Etc.
z Limit the # of significant factors
– Usually no more than 5
z Find out which factors are significant
– By regressing the stocks returns on different sets of factors
Macroeconomic variables approach:
pros and cons

z Advantages:
– Very intuitive
– Names the exact factors that determine the stocks
returns
z Disadvantages:
– Potentially important factors may be difficult to
quantify (e.g., political changes)
– ‘Factors’ are constructed as ‘unanticipated’ changes,
which might be difficult to measure
– Multicollinearity issues
An example

z Let the only factor affecting the returns be Fint, the news
on interest rates
z Before the FOMC meeting, the market participants
expect the FED not to change the base rate: E(Fint) = 0
z After the meeting, B. Bernanke announces that the
interest rate is raised by 25 b.p. => Fint = 0.25 > 0
z What should the sensitivities to Fint be for:
– Fixed income securities?
– Stocks?
– Commodities?
Macroeconomic variables approach:
empirical findings

z Chen, Roll & Ross (1986)

– Important factors:
z Changes in GDP growth rate
z Changes in default risk premium (spread b/w YTM on AAA and
BBB rated bonds)
z Changes in the slope of the YC (spread b/w LT and ST bonds
rates)
– Less significant factors:
z Unexpected changes in the price level (difference b/w actual and
expected inflation rates)
z Changes in expected inflation (T-bill yield)
– Unimportant:
z The return on market index, when added to the regression, could
not explain the expected returns
Macroeconomic variables approach:
empirical findings

z Chan, Chen & Hsieh (1985); Jagannathan &

Wang (1996)
– Identified default spread and labor income as
systematic factors associated with positive risk-
premiums
– Research on explaining the small firm effect
z Small cap stock returns appeared to be highly correlated
with changes in the spread b/w BBB and default-free bonds
z The spread seems to be a fairly good predictor of future
market returns
z Betas are higher when the spread is high
Characteristic-sorted portfolios
approach

z Identify the possible characteristics:

– Size
– Forward-looking indicators (B/M)
– Backward-looking indicators (stock’s performance
during the past 6-12 months)
– Etc.
z Group portfolios of stocks that satisfy the above
characteristics
z Calculate the risk premiums associated with the
respective characteristic (risk factor)
Characteristic-sorted portfolios
approach: pros and cons

z Advantages:
– The approach is based NOT on cross-correlations
between individual securities, but on the correlation
with some common characteristic => does not
require the constant correlation assumption
– Uses portfolios returns, which are highly
unpredictable, but observable, to calculate factor risk
premiums
z Disadvantages:
– Relationships found in historical data are not
guaranteed to have explanatory power in the future
Characteristic-sorted portfolios
approach: empirical findings

z Fama & French (1993)

– Suggested a 3-factor model composed of the
following three zero-cost (self-financing) portfolios:
z Value-weighted index portfolio (long) + T-bills (short)
z High book-to-market stocks (long) + low book-to-market
stocks (short)
z Small-firm stocks (long) + large-firm stocks (long)
– Estimated risk-premiums for each factor (b/w 1963
and 1994)
z 5.2%; 3.2%; 5.4%
Characteristic-sorted portfolios
approach: empirical findings

– Estimated the factor sensitivities for stocks in

different industry groups:
Characteristic-sorted portfolios
approach: empirical findings

9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
0,7 0,8 0,9 1 1,1 1,2 1,3

Risk-premium (multi-factor) Risk-premium (CAPM)

APT vs. CAPM – 1

z Desired portfolio:
– CAPM: two-fund separation theorem states that all
investors will form their desired portfolios by
combining only 2 assets – the risk-free asset and
the market portfolio
– APT: in a complete market the desired portfolio can
be formed by combining the factor-replicating
portfolios and the risk-free asset
z Securities pricing under both theories:
– Assets with identical risk exposures must bring
identical returns => otherwise arbitrage is possible
APT vs. CAPM – 2

z Sources of risk:
– CAPM: fluctuations of the market portfolio returns
– APT: fluctuations in various risk factors
(macroeconomic, financial, political, etc.)
z Assumptions: APT is less restrictive
– It doesn’t require investors to have homogenous
expectations
– CAPM – a pure theoretical framework
– APT – a practical framework
Assumptions (APT)

z In equilibrium there are no arbitrage opportunities

z Returns of risky assets can be described by a factor
model
z Financial markets are frictionless
– No transaction costs
– Perfect information, etc.
z There is a large number of securities => investors
hold well-diversified portfolios => specific risks are
diversified away; the only source of risk arises from
fluctuations in factors determining the return
APT vs. CAPM: Summary

z APT solves the major problem of CAPM

– It does not require to determine the market
portfolio
z APT doesn’t name the particular factors that
should be used to determine the expected
returns
– As opposed to CAPM, which specifies the
particular source of risk
z Both models state that only systematic (non-
diversifiable) risk should be rewarded
A formal link b/w CAPM and APT

z Consider a one-factor model, where F if other

than the return on the market portfolio
– Ri = ai + biF + εi
z Assuming CAPM holds, and there is some
correlation (ρ) b/w F and Market portfolio, the
stock’s β can be calculated as following:
ρ
β i = bi 2
σM
z The case can be extrapolated to the case of a
multi-factor model
Essential reading

z Brealey, Myers: Principles of Corporate

Finance, Seventh Edition
– Chapter 8.4
z Grinblatt, Titman: Financial Markets and
Corporate Strategy, Second Edition
– Chapter 6