Multifactor Models of Risk and Return: Dr. Amir Rafique

Multifactor Models of
Risk and Return
Dr. Amir Rafique

Arbitrage Pricing Theory (APT)
 CAPM-The most useful model but also has
shortcomings:
 Single factor model
 Beta is not stable
 Proxy for the market portfolio as a benchmark
 APT was developed by Ross (1976)

 Alternative to CAPM
 Limited assumptions
 Multiple dimensions of risk
 The major challenges in implementing APT
are:
 Risk factors in the model are not defined in terms
of their quantity (how many they are?)
 Or their identity (what they are?)

APT-Assumptions
 Three major assumptions:
1. Capital markets are perfectly competitive
2. Investors always prefer more wealth to less wealth with

certainty
3. Asset returns can be expressed as a linear function of a

set of K risk factors
R t  E t  b i 1 i  b i 2  i  ...  b i k  k   i
For i = 1 to N where:
Ri = actual return on asset i during a specified time period
Ei = expected return for asset i
bik = reaction in asset i’s returns to movements in a
common risk factor
 k = a common factor with a zero mean that influences
the returns on all assets
i = a unique effect on asset i’s return that, by
assumption, is completely diversifiable in large
portfolios and has a mean of zero
N = number of assets
Comparing the CAPM & APT
Models
CAPM APT
Form of Equation Linear Linear
Number of Risk Factors 1 K (≥ 1)
Factor Risk Premium [E(RM) – RFR] {λj}
Factor Risk Sensitivity βi {bij}
“Zero-Beta” Return RFR λ0
Unlike CAPM that is a one-factor model, APT

is a multifactor pricing model
The difference is how systematic risk is
defined
Using the APT
 For illustration, assume that there are two
common factors
 First risk factor: Unanticipated changes in the rate of

inflation
 Second risk factor: Unexpected changes in the growth

rate of real GDP
Example of Two Stocks
and a Two-Factor Model
1 = changes in the rate of inflation. The risk premium

related to this factor is 1 percent for every 1 percent
change in the rate (   . 01)
1
2 = percent growth in real GNP. The average risk

premium related to this factor is 2 percent for every
1 percent change in the rate (   . 02 )
2
0 = the rate of return on a zero-systematic-risk asset

(zero beta) is 3 percent (   . 03 )
0
bx1 = the response of asset X to changes in the rate of
inflation is 0.50 ( b x 1  . 50 )
by1 = the response of asset Y to changes in the rate of

inflation is 2.00 ( b y 1  2 )
bx 2 = the response of asset X to( bchanges in the growth

 1 .5 0 )
rate of real GNP is 1.50 x2
by 2 = the response of asset Y to changes in the growth

rate of real GNP is 1.75 ( b y 2  1 . 7 5 )
E i   0   1b i1   2 b i 2
= .03 + (.01)bi1 + (.02)bi2
Ex = .03 + (.01)(0.50) + (.02)(1.50)
= .065 = 6.5%
Ey = .03 + (.01)(2.00) + (.02)(1.75)
= .085 = 8.5%
Multifactor Models and Risk
Estimation
 Two general approaches have been
employed in factors identification process:
 Macroeconomic-Based Risk Factor Models
 Microeconomic-Based Risk Factor Models/

Characteristic-Based Risk Factor Models
Fama-French Three-Factor Model
 Fama and French (1993) developed a
multifactor model (The 3Factor Model):
R- Rf  ai  bi1 ( Rmt - RFRt )  bi 2 SMBt  bi 3 HMLt  eit
 SMB (i.e. small minus big) is the return to a portfolio of small

capitalization stocks less the return to a portfolio of large
capitalization stocks
 HML (i.e. high minus low) is the 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
Carhart Four Factor Model
Carhart (1997), based on the Fama-French three factor

model, developed a four-factor model by including a risk factor
that accounts for the tendency for firms with positive past
return to produce positive future return
R-it Rf ai  bi1 ( Rmt - RFR t )  bi 2 SMB t  bi 3 HML t  bi 4 MOM t  eit
where, MOMt = the momentum factor

Fama-French Five-Factor Model
 A five-factor model adds profitability (RMW) and
investment (CMA) factors to the three-factor model
of Fama and French (1993). RMW and CMA (stock
returns that behave like those of profitable firms that
invest conservatively) capture the high average returns
R- Rf = 𝑎𝑖 +𝑏𝑖(𝑅𝑀𝑡 −𝑅𝐹𝑡)+𝑠𝑖𝑆𝑀𝐵𝑡 +ℎ𝑖𝐻𝑀𝐿𝑡 +𝑟𝑖𝑅𝑀𝑊𝑡 +𝑐𝑖𝐶𝑀𝐴𝑡 +𝑒𝑖𝑡
Profitability and Investment are the added factors.

Estimating Expected Returns
for Individual Stocks
 Steps involve in multifactor models:
(1) a specific set of K common risk factors (or
their proxies) must be identified,
(2) the risk premia  k for the factors must be
estimated,
(3) the sensitivities (bik) of the ith stock to each
of those K factors must be estimated, and
(4) the expected returns can be calculated by
combining the results of the previous steps.
Issues

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Multifactor Models of

Risk and Return

Dr. Amir Rafique

 APT was developed by Ross (1976)

 Or their identity (what they are?)

1. Capital markets are perfectly competitive

2. Investors always prefer more wealth to less wealth with

3. Asset returns can be expressed as a linear function of a

Unlike CAPM that is a one-factor model, APT

 First risk factor: Unanticipated changes in the rate of

 Second risk factor: Unexpected changes in the growth

1 = changes in the rate of inflation. The risk premium

2 = percent growth in real GNP. The average risk

0 = the rate of return on a zero-systematic-risk asset

by1 = the response of asset Y to changes in the rate of

bx 2 = the response of asset X to( bchanges in the growth

by 2 = the response of asset Y to changes in the growth

 Macroeconomic-Based Risk Factor Models

 Microeconomic-Based Risk Factor Models/

R- Rf  ai  bi1 ( Rmt - RFRt )  bi 2 SMBt  bi 3 HMLt  eit

 SMB (i.e. small minus big) is the return to a portfolio of small

Carhart (1997), based on the Fama-French three factor

R-it Rf ai  bi1 ( Rmt - RFR t )  bi 2 SMB t  bi 3 HML t  bi 4 MOM t  eit

where, MOMt = the momentum factor

R- Rf = 𝑎𝑖 +𝑏𝑖(𝑅𝑀𝑡 −𝑅𝐹𝑡)+𝑠𝑖𝑆𝑀𝐵𝑡 +ℎ𝑖𝐻𝑀𝐿𝑡 +𝑟𝑖𝑅𝑀𝑊𝑡 +𝑐𝑖𝐶𝑀𝐴𝑡 +𝑒𝑖𝑡

Profitability and Investment are the added factors.

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