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CHAPTER
11
An Alternative View of
Risk and Return: The
APT
McGraw-Hill/Irwin
Corporate Finance, 7/e
11-2
Chapter Outline
11.1 Factor Models: Announcements, Surprises, and
Expected Returns
11.2 Risk: Systematic and Unsystematic
11.3 Systematic Risk and Betas
11.4 Portfolios and Factor Models
11.5 Betas and Expected Returns
11.6 The Capital Asset Pricing Model and the
Arbitrage Pricing Theory
11.7 Parametric Approaches to Asset Pricing
11.8 Summary and Conclusions
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Corporate Finance, 7/e
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11-4
11-5
11-6
11-7
R R U
Total risk; U
becomes
R R m
Nonsystematic Risk;
Systematic Risk; m
where
m is the systematic risk
is the unsystematic risk
n
McGraw-Hill/Irwin
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Cov ( Ri , RM )
i
2 ( RM )
11-9
Inflation
GDP growth
The dollar-euro
spot exchange
rate, S($,)
R R m
R R I FI GDP FGDP S FS
I is the inflation beta
GDP is the GDP beta
S is the spot exchange rate beta
is the unsystematic risk
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1111
1112
If it was the case that the rate of GDP growth was expected
to be 4%, but in fact was 1%, then
FGDP = Surprise in the rate of GDP growth
= actual expected
= 1% 4%
= 3%
R R 2.30 5% 1.50 ( 3%) 0.50 FS 1%
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1114
1115
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Ri R i i F i
If we assume
that there is no
unsystematic
risk, then i = 0
The return on the factor F
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Ri R i i F
If we assume
that there is no
unsystematic
risk, then i = 0
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A 1.5 B 1.0
C 0.50
Different
securities will
have different
betas
McGraw-Hill/Irwin
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RP X1 R1 X 2 R2 Xi Ri X N RN
Ri Ri i F i
RP X1 ( R1 1 F 1 ) X2 ( R2 2 F 2 )
X N ( RN N F N )
RP X1 R1 X1 1 F X1 1 X2 R2 X 2 2 F X 2 2
X N RN X N N F X N N
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RP X1 R1 X2 R2 X N RN
( X1 1 X2 2 X N N ) F
X1 1 X2 2 X N N
In a large portfolio, the third row of this equation disappears as the
unsystematic risk is diversified away.
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RP X1 R1 X 2 R2 X N RN
( X1 1 X 2 2 X N N ) F
In a large portfolio, the only source of uncertainty is the portfolios
sensitivity to the factor.
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P
and
P X1 1 X N N
1123
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RF
SML
A
D
B
C
R RF ( RP RF )
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R R I FI GDP FGDP S FS
As securities are added to the portfolio, the unsystematic risks of
the individual securities offset each other. A fully diversified
portfolio has no unsystematic risk.
The CAPM can be viewed as a special case of the APT.
Empirical models try to capture the relations between returns and
stock attributes that can be measured directly from the data
without appeal to theory.
McGraw-Hill/Irwin
Corporate Finance, 7/e