Sorting Out Risks Using Known APT Factors

Abstract

Arbitrage Pricing Theory (APT) differs from the Capital Asset Pricing Model (CAPM) in hypothesizing that actual and expected security returns are sensitive, not to just one type of nondiversifiable (i.e., beta or market risk), but to a variety of different ypes of risk. Prior testing has shown the CAPM to be inferior to an APT model that incorporates unanticipated changes in five macroeconomic variables-default risk, the term structure of interest rates, inflation or deflation, the long-run expected growth rate of profits for the economy and residual market risk. It is possible to estimate the sensitivities of individual securities or portfolios to these five factors. Such measurements allow one to explore variations in sensitivities to different types of across both equity market sectors and industries. The resulting exposure profiles do not depend on any particular market index. APT profiles may be used for either active or passive portfolio management. Passive managers wishing to reduce their portfolios' systematic characteristics might consider a technique termed risk sterilization; here assets with different profiles are combined so as to negate, or sterilize, exposure to selected riskfactors. Alternatively, active managers can attempt to achieve excess returns by constructing portfolios in accordance with their forecasts of factor realizations.