Page 294 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 11: Capital Market Theory

Additionally, the APT can be seen as a “supply side” model, since its beta coefficients Notes
reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks
would cause structural changes in the asset’s expected return, or in the case of stocks, in the
firm’s profitability.

On the other side, the capital asset pricing model is considered a “demand side” model. Its
results, although similar to those in the APT, arise from a maximization problem of each
investor’s utility function, and from the resulting market equilibrium (investors are
considered to be the “consumers” of the assets).

11.10 Using the APT

Identifying the Factors

As with the CAPM, the factor-specific Betas are found via a linear regression of historical security
returns on the factor in question. Unlike the CAPM, the APT, however, does not itself reveal the
identity of its priced factors – the number and nature of these factors is likely to change over
time and between economies. As a result, this issue is essentially empirical in nature. Several a
priori guidelines as to the characteristics required of potential factors are, however, suggested:
1. Their impact on asset prices manifests in their unexpected movements.
2. They should represent undiversifiable influences (these are, clearly, more likely to be
macroeconomic rather than firm-specific in nature).
3. Timely and accurate information on these variables is required.
4. The relationship should be theoretically justifiable on economic grounds.
Chen, Roll and Ross identified the following macro-economic factors as significant in explaining
security returns:
1. Surprises in inflation;
2. Surprises in GNP as indicted by an industrial production index;

3. Surprises in investor confidence due to changes in default premium in corporate bonds;
4. Surprise shifts in the yield curve.
As a practical matter, indices or spot or futures market prices may be used in place of macro-
economic factors, which are reported at low frequency (e.g. monthly) and often with significant
estimation errors. Market indices are sometimes derived by means of factor analysis. More
direct ‘indices’ that might be used are:
1. Short-term interest rates;
2. The difference in long-term and short-term interest rates;
3. A diversified stock index such as the S&P 500 or NYSE Composite Index;

4. Oil prices
5. Gold or other precious metal prices
6. Currency exchange rates

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