20203A

Portfolio management
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Class 7
APT & Multifactor
models
© Melanie Harris 2022 (updated in Oct 2023) Source: Jean-Philippe Tarte.
 Outline class 7
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Section 1: Introduction Law of One Price

Section 2: APT model
Section 3: Factor models
 Section 1: Introduction.
General form of factor models of security returns
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Recall stock variability may be decomposed into the following sources:

 Market (i.e., systemic) risk
 Largely due to macroeconomic events
 Firm-specific (i.e., idiosyncratic) effects
Multiple risk factors.

where:
𝑅𝑖 =𝐸 ( 𝑅𝑖 ) +𝑏𝑖1 𝜆1 +𝑏 𝑖2 𝜆2 +⋯+𝑏 𝑖𝑘 𝜆 𝑘+𝜀𝑖 for 𝑖=1 to 𝑛
Ri = actual excess return on asset i during a specified time period, i = 1, 2, 3, … n. n is number
of assets
E(Ri) = expected excess return for asset i (if all the risk factors have zero changes)
bij = Factor surprise sensitivity or factor loading or factor beta. Sensitivity of asset i’s returns
to movements in the common risk factor j
k = surprise in common factor k (k could be positive or negative but has an expected value of
zero and influences the returns on all assets). k number of factors.
εi = firm-specific surprise events of asset i unrelated to the macro factors (a random error term
that, by assumption, is completely diversifiable in large portfolios and has a mean of zero)
The general form is a description of the factors that affect security returns…
Where comes from? We need a theoretical model of equilibrium security
returns to help determine the expected value …
 Section 2: Arbitrage pricing theory (APT model)
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A. Assumptions and equation

B. Comparing the CAPM and the APT
C. Using the APT: Two-stock and a two-factor model
example
 A – Assumptions and equation
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 APT developed by Ross (1976). An alternative to CAPM. A multifactor

model.
and 2 factor SML.

and
APT isR intuitive and makes fewer assumptions than CAPM. 1Equilibrium
= excess return factor SML.
model.

 Three major assumptions:

 A factor model describes asset returns

 With many assets to choose from, investors can form well-diversified portfolios that eliminate

asset-specific risk
 No arbitrage opportunities exist among well-diversified portfolios.

 In contrast to CAPM, APT does not assume:

 Normally distributed security returns

 Quadratic utility function

 A mean-variance efficient market portfolio

 Assumptions and equation
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 APT is a return-generating process that can be represented as a K factor model

 Assuming that a risk-free investment yields r , we find that in equilibrium, the
f
expected return on any asset i can be expressed as:

Risk premium
related to the jth
common risk factor

Fundamental
equation of the 𝐸 (𝑟 𝑖)=𝑟 𝑓 +𝜆1𝑏𝑖1+ 𝜆2𝑏𝑖2+...+ 𝜆𝑘𝑏𝑖𝑘
APT Number of
Risk-free Sensitivity of factors k
rate an asset i to
What are those
factor j
factors?
Factor betas or How many do we
Equation of APT Factor loadings
similar to CAPM
𝐸 ( 𝑟 𝑖 ) =𝑟 𝑓 +[ 𝐸 ( 𝑟 𝑀 ) −𝑟 ] 𝛽𝑓
have?
Ross
𝑖 doesn’t say!!
 Assumptions and equation
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 Risk factors (l)

 Factor affecting the return on all assets (common to
all assets)
 These factors must be identified and can be of several
kinds (macroeconomic, microeconomic, statistical,
etc.)
Coefficients are
 Sensitivities to risk factors (bik) often estimated
 The sensitivity factor (l) impacts each of the using a
securities differently statistical
 Thus, each security "i" will have a particular technique
sensitivity for each of the risk factors "k“ measured by ‘factor
bik analysis’
However, when it is time to apply the theory, there is no indication of
what these factors represent… And how many!
 B - Comparing the CAPM and the APT
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CAPM APT
Form of the equation Linear Linear
Number of risk factors 1 K (1)
Premium of the risk factor E(Rm)-Rf {λi}
Sensitivity to the risk factor i {bik}
« zero-beta » return Rf Rf
 Remarks:
 APT admits a universe where securities are influenced by more than
one factor.
 The graphical representation as well as the modeling of the
investment universe are potentially highly complexified for APT.
 APT allows for greater flexibility in the design and risk nature of
 C - Using the APT: Two-stock and a two-factor model example
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 Assume that there are two common factors: one related to unexpected
changes in the level of inflation and another related to unanticipated
changes in the real level of GDP.

 Risk factor definitions and sensitivities:

δ1 = The risk premium related to this factor is 2 percent for every 1 percent change in the rate (λ = 0.02).
δ2 = The average risk premium related to this factor is 3 percent for every 1 percent change in the rate growth
(λ2 = 0.03).
λ0 = rate of return on a zero-systematic risk asset (zero-beta) is 4 percent (λ0 = 0.04) = rf

 Assume also that there are two assets (x and y) that have the following
sensitivities to these common risk factors:
bx1 = response of Asset x to changes in the inflation factor is 0.50
bx2 = response of Asset x to changes in the GDP factor is 1.50
by1 = response of Asset y to changes in the inflation factor is 2.00
by2 = response of Asset y to changes in the GDP factor is 1.75
Using the APT: Two-stock and a two-factor model example
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 Under the APT model, what should be the expected return of the 2
securities?
** See Reilly &
Brown
Chapter 7

And appendix

AOA
If the prices of the two assets do not reflect expected returns, we would
expect investors to enter into arbitrage arrangements selling overpriced
assets (short) and using the proceeds to purchase the underpriced assets
until the relevant prices are corrected.

Price relationships that satisfy the no-arbitrage condition are important because
we expect them to hold in real-world markets.
 When it comes to putting theory into practice…
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CAPM framework specifies the single risk factor: excess

return to the market portfolio. Process of estimation
quite straightforward.
 Challenge: a set of restrictive assumptions and potential correlated
residuals.

APT is a theoretical and elegant model. Free of many

restrictive assumptions of CAPM.
 Challenge: the inability to identify the risk factors.

Potential solution to APT? Other multifactor models.

 Section 3: Factor models
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A. Multifactor models of security market returns are divided into

three types
B. Macroeconomic-based risk factor model
C. Statistical factor model
D. Fundamental-based risk factor model
E. Practical uses of multifactor models
 A - Multifactor models of security market returns are divided into
three types
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Macroeconomic factor
1 models Risk factors can be viewed as
macroeconomic in nature
2 Statistical factor models Risk factors are not specified

3 Fundamental factor models Risk factors can also be viewed at a

microeconomic level

 A wide variety of empirical factor specifications have been employed in

practice. (APT is quite theoretical…).
 Each alternative models attempt to identify a set of economic influences.
 Empirical studies are inconclusive on the number of factors to retain.
Thus, there is a low use of statistical factors.
 Economic factors, allowing for an economic interpretation between risk
factors and the performance of securities or portfolios, are favored.
 B - Macroeconomic-based risk factor model
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 In a multifactor model, the analyst chooses the exact number and

identity of risk factors, while the APT model does not specify either of
them and the CAPM only specifies one.
 Use the observable economic time series as the factors. Examples: inflation, economic
growth, interest rates, FX rates etc.
 Models assume that security returns responds linearly to the macroeconomic
shocks.
 Using forecasts of macroeconomic factors to predict security
Fit = Period t return to the
returns. jth designated risk factor

𝑅𝑖𝑡 =𝑎𝑖 + [ 𝑏𝑖1 𝐹 1 𝑡 +𝑏𝑖2 𝐹 2𝑡 +…+𝑏𝑖𝐾 𝐹 𝐾𝑡 ] +𝑒 𝑖𝑡

Rit = Security i’s return that can be = is the portion of security i
measured as either a nominal return that may not be
or excess return to security i explained by the factor
model
 Macroeconomic-based risk factor model
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CRR model. Developed by Chen, Roll and Ross (1986)

The macroeconomic variables considered are:

1. Returns of the NYSE index

2. Monthly growth of industrial production
3. Variation of the CPI
4. Difference between expected and actual CPI
5. Unanticipated changes in the credit spread (=Baa-Rf)
6. Unanticipated changes in the spot yield curve (=LT – ST rf)

Their findings: The key contribution of their research was to

demonstrate that factors beyond the market portfolio could
significantly explain variations in stock returns, thereby supporting
the multifactor approach of APT. However, economic significance of
risk factors changed over time.
 Macroeconomic-based risk factor model
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BIRR model. Developed by Burmeister, Ibbotson,

Roll and Ross (1994).

Analyzed the predictive ability of a model based on the

following set of macroeconomic factors:
1. Confidence risk
2. Time horizon risk
3. Inflation risk
4. Business cycle risk
5. Market timing risk
 Macroeconomic-based risk factor model BIRR
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 Investor confidence
 Risk associated with unanticipated changes in investor confidence in investing in
risky securities (or portfolios)
 Many financial assets have a positive sensitivity to the confidence risk factor. An
unexpected increase in investor confidence leads to an appreciation in the value of
securities and portfolios with a high positive sensitivity to this factor
 Some securities have a negative sensitivity to the risk factor of confidence: they are
so-called "safe haven“.

 Risk relating to the time horizon

 Risk due to unanticipated changes in the willingness of investors to invest for a long
term
 Growth stocks have a stronger (positive) sensitivity vs value stocks
 Sensitivity to this factor can be positive or negative
 Macroeconomic-based risk factor model :
BIRR
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 Risk relating to inflation

 Risk related to unanticipated changes in the rate of inflation
 An increase in inflation brings downward pressure on the stock
market
 Securities with the highest sensitivities :
 Securities in the retail sector
 Hotels and leisure services
 Sectors selling luxury goods
 Securities with the lowest sensitivities: consumer staples and other
basic goods and services firms
 Few stocks attract investors in times of high inflation
 Macroeconomic-based risk factor model :
BIRR
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 Risk relating to business cycle

 Risk related to unanticipated changes in the growth rate of the national
economic activity (generally GDP growth rate)
 Sectors performing better in times of economic growth have a positive (high)
sensitivity to this risk factor (e.g. retail)
 stocks in the utilities sector have low and even negative sensitivity to this factor

 Risk relating to market timing

 Linked to unanticipated changes in the stock market that can not be explained by
other macroeconomic factors
 Corresponds to the market risk of the CAPM; interpretation identical to that of
the CAPM beta
 Difference from CAPM: residual market risk measure i.e.. risk not captured by
other factors
 Macroeconomic-based risk factor model :
BIRR
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Risk Factor Risk Premium

If found empirically, the premia areConfidence
: 2.59%
Time Horizon -0.66%
Inflation -4.32%
Business Cycle 1.49%
Market timing 3.61%
Source: Rilley and Brown

Example: find the expected return on a market index

Contribution of the risk
Exposure to the risk factor to the expected
Risk Factor Risk Premium of the S&P 500 return of the S&P 500
Confidence 2.59% 0.27 0.70%
Time Horizon -0.66% 0.56 -0.37%
Inflation -4.32% -0.37 1.60%
Business Cycle 1.49% 1.71 2.55%
Market timing 3.61% 1 3.61%
Expected excess return
over the risk-free rate
of the S&P 500 8.09%
 Macroeconomic-based risk factor model :
BIRR
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From the previous results, we can generalize the BIRR

model using the following equation :

𝐸(𝑅𝑖)=𝑟𝑓 +𝛽𝑖1(2.59)+𝛽𝑖2(−0.66)+𝛽𝑖3(−4.32)+𝛽𝑖4(1.49)+𝛽𝑖5(3.61)
where,
Rf : risk-free rate (T-bills)
βij = sensitivity of security i to factor j for j = 1,…5
 C – Statistical factor model
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 Definition:
 Statistical factor models are models employed to a set of historical returns to
determine factors that explain historical returns
 Objective:
 to look for unrelated (uncorrelated) factors that explain observed historical
returns on securities: APT Tests
 Types:
 Factor analysis models

 Principal component analysis (PCA)

 The actual nature of the factors is not specified by the model. These models
make no assumptions.
 Not very useful for portfolio management: problems of interpretation.
Another drawback is the need for a long and stable history of returns for
accurate estimation of factor betas.
 D - Fundamental-based risk factor model
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Characteristic-based approach. Microeconomic models.

Use observed company attributes as factor betas since they
explain a considerable proportion of common return.
 Examples: market capitalization, P/E ratio, financial leverage etc.
 Factors tend to be correlated for firms in the same industry.
 With this approach, the analyst decides precisely how many and
what attributes need to be estimated

List of some models:

1) Fama & French three factor model The factors are the
returns estimated
2) Fama & French four factor model
using cross-
3) And many others…
sectional regression
 1) Fama & French three factor model
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 The FF three-factor model puts three factors forward (1993):

( 𝑅 𝑖𝑡 − 𝑅𝐹 𝑅𝑡 ) =𝛼 𝑖 +𝑏 𝑖1 ( 𝑅 M𝑡 − 𝑅𝐹 𝑅𝑡 ) +𝑏𝑖2 𝑆𝑀 𝐵𝑡 +𝑏𝑖 3 𝐻𝑀 𝐿𝑡 +𝑒𝑖𝑡

1. Size of firms. The firm size factor, also known as SMB (small minus
big). Equal to the return to a portfolio of small capitalization stocks less
the return to a portfolio of large capitalization stocks.
2. Book-to-market ratio: HML (High Minus Low): return to a portfolio
of stocks with high ratios of book-to-market values less the return to a
portfolio of low book-to-market value stocks
3. Excess return on the market. The market: market portfolio return
minus return on risk-free rate (market risk premium)

It is a better approach than the Capital Asset Pricing Model (CAPM),

as CAPM explains 70% of a portfolio’s diversified returns, whereas
Fama-French explains roughly 90%.
 2) Fama & French four factor model
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Fama, French & Carhart 1997:

( 𝑅 𝑖𝑡 − 𝑅𝐹 𝑅𝑡 ) =𝛼 𝑖 +𝑏𝑖1 ( 𝑅 M𝑡 − 𝑅𝐹 𝑅𝑡 ) +𝑏𝑖2 𝑆𝑀 𝐵𝑡 +𝑏𝑖 3 𝐻𝑀 𝐿𝑡 +𝑏𝑖 4 𝑀𝑂 𝑀 𝑡 +𝑒𝑖𝑡

1. SMB & HML & market premium: same definition as before

2. MOM (Momentum): New factor. Return of a portfolio of the

best stocks over the period minus the return of the worst
stocks.

The Cahart model is considered a superior one, given its explanatory

power of around 95%.
 3) Other models
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SBB model. Developed by Salomon - Smith - Barney

1. Variation in the anticipated long term economic growth rate (risk of long-term
economic growth): measured by the monthly change in the growth rate of
industrial production
2. Short term business cycle (short-term business cycle risk): change in the spread
between the 20-year corporate bond yield and the Treasury bond yield of the
same maturity
3. Variation in the yields of long-term bonds (long-term interest rate risk):
measured by the change in the yield on 10-year Treasury bonds
4. Variation in the yields on Treasury bills (short-term interest rate risk): measured
by the change in the yield on short-term treasury bills; usually 1 or 3 months
5. Unanticipated change in the rate of inflation (inflation risk): This is the
difference between the realized inflation rate and the expected inflation rate (by
reliable estimation models!)
6. Change in the value of the dollar against currencies of main trade partners:
 BARRA model
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Developed by MSCI Barra 1. Volatility

13 fundamental microeconomic 2. Momentum
3. Market capitalization
variables are considered. 4. Linearity of earnings vs
Specificities: market cap.
5. Volume of transactions
 A factor is specific to the security’s 6. Growth
industry 7. Profit Margin
 International specificity 8. Value Index
9. Variability of earnings
10. Financial Leverage
11. Sensitivity to currency
12. Dividend yield
13. Non estimated indicators
 Wilshire/Atlas
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1. P/E ratio: Last share price divided by the sum of the last 4 quarterly
earnings per share (EPS)
2. Book/Market ratio: Last share price / book value per share
3. Market capitalization
4. Review of net earnings by analysts or measurement of analysts'
momentum : % of analysts who have revised upward earnings per share
of the company; analysts' momentum or enthusiasm about the security
5. “Reversal” : difference between the return realized in the last period on
the security and the "normal" return expected given the beta of the
security
6. The “torpedo” of returns or the measure of profit momentum : measure
of the anticipated growth rate of EPS relative to the historical growth
rate of the company's EPS
7. Historical Beta (CAPM): market (systematic) risk of the security.
Calculated using monthly data for the last 5 years (minimum of 38 latest
monthly observations)
 Goldman Sachs
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Not marketed (used internally by the company)

1. P/E ratio
2. Retained earnings per share / price
3. Earnings before tax, interest and amortization /(Market value of shares + Book
value of long term debt)
4. Revision of analysts' forecasts over the past 3 months: (Number of upward
revision - Number of downward revisions) / (Total number of analyst forecasts)
5. Momentum of share price : Total return over the last 12 months - Last month's
return
6. Sustainable growth : Average (market consensus) long-term growth rate
7. Historical Beta (CAPM) : Estimated over 5 years by regression of excess returns of
securities on excess market return
8. Risk of unpleasant surprise : Risk that the realized EPS are lower than the
expected EPS (similar to torpedo of earnings in the Wilshire Atlas model)
9. Residual Risk : Specific risk, not explained by market variations
 When it comes to putting theory into
practice…
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 It is probably safe to assume that both the CAPM and multifactor

models will continue to be used to value capital assets.

 Further empirical tests of those theories needed.

 The ultimate goal being to determine which theory does the best
job of explaining current returns and predicting future ones.

 Subsequent work in this area will seek to identify the set of

factors that best captures the relevant dimension of investment
risk as well as explore the intertemporal dynamics of the models
(for example, factor betas and risk premia that change over
time).
 E– Practical uses of multifactor models
Active management Passive management
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Risk Management
Models determine the  These models are used in Exposure of an asset to
required rates of return for constructing portfolios multiple risk factors guides
each security based on that obtain a consistent decisions about its inclusion in
identified risk factors. result on the a portfolio according to the
characteristics of the risk management strategy and
These models help in benchmark. the level of risk tolerated by
establishing intended the client
exposures to various risk  Replicates a stock market
factors. index at a lower cost Knowledge of the portfolio's
(reducing the number of exposure versus that of the
securities to reduce market: allows to identify the
Active managers can thus manager's bets.
use multifactor models to transaction costs when
make bets on desired buying and rebalancing).
The presence of securities
factors while hedging or with different levels of
even remaining neutral on exposure to risk factors:
the other factors. portfolio diversification
strategy (combining multiple
assets with different risk
Extract from formula sheet midterm (more formulas are available for
midterm – see sheet ZC/Midterm)
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Exercices to complete on ZC
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Q4 & Q5