Pricing Theory 12.6 Empirical Approaches to Asset Pric1 Introduction
Arbitrage Pricing Theory
Arbitrage arises if an investor can construct a zero investment portfolio with a sure profit.
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 FI 1.50 FGNP 0.50 FS 1%
Chapter 12
An Alternative View of Risk and Return: The Arbitrage Pricing Theory
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Key Concepts and Skills
Discuss the relative importance of systematic and unsystematic risk in determining a portfolio’s return
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Total Risk
Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure
of total risk. For well-diversified portfolios, unsystematic
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Systematic Risk and Betas: Example
R R βI FI βGNPFGNP βS FS ε
Suppose we have made the following estimates:
1. bI = -2.30 2. bGNP = 1.50 3. bS = 0.50
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Systematic Risk and Betas: Example
R R 2.30 FI 1.50 FGNP 0.50 FS 1% We must decide what surprises took place in the
Compare and contrast the CAPM and Arbitrage Pricing Theory
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Chapter Outline
12.1 Introduction 12.2 Systematic Risk and Betas 12.3 Portfolios and Factor Models 12.4 Betas and Expected Returns 12.5 The Capital Asset Pricing Model and the Arbitrage
Our model is:
R Rmε
R R βI FI βGNP FGNP βS FS ε
βI is the inflation beta
βGNP is the GNP beta
βS is the spot exchange rate beta 7
ε is the unsystemat ic risk
Systematic Risk: m
where m is the systematic risk ε is the unsystemat ic risk
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n
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12.2 Systematic Risk and Betas
The beta coefficient, b, tells us the response of the stock’s return to a systematic risk.
In the CAPM, b measures the responsiveness of a security’s return to a specific risk factor, the return on the market portfolio.
bi

Cov( Ri , RM
2 (RM )
Since no investment is required, an investor can create large positions to secure large levels of profit.
In efficient markets, profitable arbitrage opportunities will quickly disappear.
We can break down the total risk of holding a stock into
two components: systematic risk and unsystematic risk:
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Total risk
R RU becomes

R Rmε
Nonsystematic Risk:
risk is very small. Consequently, the total risk for a diversified
portfolio is essentially equivalent to the systematic risk.
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Risk: Systematic and Unsystematic
)
• We shall now consider other types of systematic risk.
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Systematic Risk and Betas
For example, suppose we have identified three systematic risks: inflation, GNP growth, and the dollar-euro spot exchange rate, S($,€).