MULTI-FACTOR MODELS

 Arbitrage Pricing Model

 The FF Three Factor Model
 The Carhart Four Factor Model
 The FF Five Factor Model

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 Outline
 Background and Explanation
 Arbitrage Pricing Model
 The FF Three Factor Model
 The Carhart Four Factor Model
 The FF Five Factor Model

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Arbitrage Pricing Theory

Stephen Ross Model

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 Background and Explanation
 The model was created in 1976 by
Stephen Ross.
 This theory predicts a relationship
between the returns of a portfolio
and the returns of a single asset
through a linear combination of
many independent macro-
economic variables.
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 Background and Explanation
 An asset pricing model based on the idea
that asset's returns can be predicted using
the relationship between that same asset
and many common risk factors.

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 Background and Explanation
 The arbitrage pricing theory (APT)
describes the price where a
mispriced asset is expected to be.
 Arbitrage means; a practice of
taking an advantage of a price
difference of a traded security
between two or more markets.

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APT
 Moreover; Arbitrage means:
simultaneous purchase and
sale of an asset in order to
profit from a price difference.
 It is often viewed as an alternative
to the Capital Asset Pricing Model
(CAPM), since the APT has more
flexible assumption requirements. 
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 Background and Explanation
 A mispriced security will have a
price that differs from the
theoretical price predicted by the
model.

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APT
 By going short (Selling Position) an
over priced security, while
concurrently going long (Buying
Position), an under priced security,
an arbitrageur is in a position to
make a theoretically risk-free
profit.

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 APT Basics
 Arbitrage Pricing Theory (APT) is a
valuation model.
 Compared to CAPM, it uses fewer
assumptions but is harder to use.
 APT is an equilibrium factor model
of security returns

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 APT Basics
Principle of Arbitrage
 The earning of riskless
profit by taking advantage
of differentiated pricing for
the same physical asset or
security.

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APT
Arbitrage Portfolio
 requires no additional
investor funds
 has positive expected
returns

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 APT Assumptions
The assumptions necessary for the APT
are:
 All securities have finite expected

values and variances.

 Some agents can form well
diversified portfolios
 There are no taxes

 There are no transaction costs

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 The Formula
 The Basis of Arbitrage Pricing Theory is
the idea that the price of a security is
driven by a number of factors.
 These can be divided into two groups:
i. Macro factors
ii. Company specific factors.

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 The Formula
 r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅
 where r is the expected return on the
security,
rf is the risk free rate,
Each f is a separate factor and
each β is a measure of the relationship
between the security price and that
factor.
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 What are the Systematic risk
Factors?
 The theory does not say what the
factors are.
 However, some published papers
document that the factors include; an
oil price, interest rate, inflation,
exchange rates, industry
production levels, personal
consumption and money supply.
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 How APT Differs from CAPM?
 The difference between CAPM and
APT is that CAPM has a single non-
company factor and a single beta,
whereas APT separates out non-
company factors into as many as
proves necessary.

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How APT Differs from CAPM?
 Each factor requires a separate
beta
 The beta of each factor is the
sensitivity of the price of the
security to that factor.

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 How APT Differs from CAPM?
 APT does not rely on measuring the
performance of the market. Instead,
APT directly relates the price of the
security to the fundamental factors
driving it.
 The problem with APT is that it
provides no indication of what these
factors are, so they need to be
empirically determined.
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 How APT Differs from CAPM?
 The potentially large number of factors
means more betas to be calculated.
 There is also no guarantee that all the
relevant factors have been identified.
 This added complexity is the reason
APT is far less widely used than CAPM.

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 Detailed Formula
ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK

where
ri = rRF +(d1-rRF )bi1 + (d 2-
rRF)bi2+ . . .
+(d-rRF)biK
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 Detailed Formula
where r is the return on security i
l0 is the risk free rate
d is the expected return on a security (a
portfolio).
b is the factor
e is the error term
NB: l is a measure of risk premium or the
extra return required by investors as
compensation for absorbing the security’s
sensitivity to the factors.
Therefore, a stock’s expected return is equal to the risk free rate
plus k risk premiums based on the stock’s sensitivities to the k
factors.
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 Detailed Formula


 Expected Returns =


R
f(
r
1
r
)
1
f
2
(
r
r
2
f
)
3
(
r
r
3
f
)
4
(
r
r
4
f
)

...
(
r
n
nr
)
f
 Where, β1 stands for security's beta with
respect to the first risk factor, β2 stands for
security's beta with respect to the second risk
factor and so on.
 The terms in the brackets are the risk
premiums for each of the factors in the
model. 23
 Example
 Suppose that two factors have been identified for the U.S.
economy: the growth rate of industrial production, IP, and
the inflation rate, IR. IP is expected to be 4%, and IR 6%.
A stock with a beta of 1.0 on IP and 0.4 on IR currently is
expected to provide a rate of return of 14%. If industrial
production actually increases to 5%, while the inflation
rate turns out to be 7%, what is your revised estimate of
the realized return on the stock?

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 Example
 We know E(IP) = 4% and Beta (IP) = 1, E(IR) = 6%, beta (IR) = 0.4,
and E(ri) = 14%
 The two factors are therefore:
 F(IP) = (0.05-0.04) = 0.01

 F(IR) = (0.07-0.06) = 0.01

 Plug these into the return generating process gives the expected return
conditional on these realization of the industrial production growth
rate (IP) and the inflation rate (IR):
 E(˜ri/ f(IP); f(IR) = 0.14+ 1x0.01+ 0.4 x0.01

 = 15.4%

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Conceptualization

1.Has APT solved all the problems of

estimating the relationship between risk
and return? Why?
2.Is beta dead, wounded or still alive and

well?

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The FF Three Factor
Model

Eugene. F. Fama and

Kenneth. R. French
(1993) Model

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The FF Three Factor Model
 This model is sometimes known as
Fama and French Model (FF Model).
 It was developed in 1993 (Fama and
French, 1993 & Fama (1996)
 Responding to critiques on CAPM and
APT, Fama and French, argued that
there are three factors explaining the
expected returns of the security.

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The FF Three Factor Model
 Principally, this is an extension of the
CAPM
 It only adds two more factors to beta in
CAPM
 Size risk premium and Value Risk
Premium

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The FF Three Factor Model
E(Rj) = Rf + 1 [E(Rm)  Rf] + 2 SMB
+ 3 HML + εi,t

Where, 2 is the sensitivity of asset or

portfolio returns to the factor SMB and 3
is the sensitivity of asset or portfolio
returns to the factor HML.

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The FF Three Factor Model
 SMB stands for Small Minus Big and
 HML stands for High Minus Low
 SMB is the measure of Size Risk : It is
also referred to as Size Premium
while
 HML is the measure of Value Risk : It is
also referred to as Value Premium.

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The FF Three Factor Model
 SMB = the difference between the
return on a portfolio of small shares
(companies with small market
capitalization) and the return on a
portfolio of large shares.
 HML = the difference between the
return on a portfolio of high book-to-
market shares and the return on a
portfolio of low book-to-market shares.
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The FF Three Factor Model
 Fama and French tested the model on
US shares
 They concluded that the model is a
good description of returns.
 The Challenge on FF Three Factor
Model: Returns may rise for small
companies or high B/M ratio companies
as a result of inefficient share pricing
not risk compensation. 33
Example
Assume that the risk premium on market portfolio is
5% and the annual risk premium for a small company
share compared with a large company share is 3%.
Also, assume that the extra return received on a share
with a high book-to-market ratio compared with a low
book-to-market ratio is 5%. If the sensitivities of the
company shares to market portfolio, size premium and
value premium are 1.5, 0.5 and 1 respectively, find the
expected risk premium and the expected return.
Assume that the risk free rate is 4%.

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Example
Solution
 Expected Risk Premium = E(R ) 
m
Rf] + SMB + HML = 5%+3%+5% =
13%
 Expected Return = R +  [E(R ) 
f 1 m
Rf] + 2 SMB + 3 HML
 = 4% + 1.5 x5% + 0.5x 3% + 1x
5% = 18%
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Questions
Has FF model solved the problem of risk-
return relationship? Is the work over?

 If not what should be done? Resorting

to techniques used by market
practitioners when determining returns?

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 The Carhart Four Factor
Model
 This is an extension to the Fama and
French three factor model (Carhart,
1997)
 There is an addition of one factor to the
FF model. This factor is called the
momentum (MOM).

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 The Carhart Four Factor
Model
 For more Reference on the Model refer
to Carhart, Mark. M (1997): On
Persistent in Mutual Fund Performance;
Journal of Finance, 52(1), 57-82.
 In stocks, momentum is the tendency
for the stock price to continue rising if it
is going up or to continue declining if it
is going down.
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The Carhart Four Factor
Model
 E(Rj) = Rf + 1 [E(Rm)  Rf] + 2
SMB + 3 HML + 4 MOM+ εi,t
 In some text books, MOM is denoted
as UMD which is the monthly premium
on winners minus losers

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THE FF FIVE FACTOR MODEL
 This model is an extension of the FF
Three Factor Model.
 It was established in 2015
 This model adds two more factors to
the FF Three Factor Model namely;
profitability and investment patterns

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THE FF FIVE FACTOR MODEL
 E(Rj) = Rf + 1 [E(Rm)  Rf] + 2
SMB + 3 HML + 4 RMW + 5 CMA +
εi,t

 Where, RMW = is the difference

between the returns on diversified
portfolios of stocks with robust and
weak profitability.
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THE FF FIVE FACTOR MODEL
 CMA is the difference between the
returns on diversified portfolios of the
stocks of Low and High investment
firms called Conservative and
Aggressive investment firms
 The evidence suggests that this model
performs better than the FF Three factor
model
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THE FF FIVE FACTOR MODEL
SHORTFALLS
 Failure to capture the low average

returns on small stocks whose returns

behave like those of firms that invest a
lot despite low profitability
 The value factor of the FF three-factor

model becomes redundant when

profitability and investment factors are
added 43
THE FF FIVE FACTOR MODEL
 The model´s performance is not
sensitive to the way its factors are
defined.

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Conceptualization
 Has the debate been resolved?
 Have APT, FF and Carhart Models
solved the CAPM Criticisms?
 Is beta dead, wounded or still alive?

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 THE END

THANK YOU

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