A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

THE QUANT QUEST FOR BETTER
MEASURES OF RISK: ARBITRAGE
PRICING THEORY
If beta is damaged as an effective quantitative measure of risk,
is there anything to take its place? One of the pioneers in the
field of risk measurement is Stephen Ross. Ross has
developed a theory of pricing in the capital markets called
arbitrage pricing theory (APT). To understand the logic of
APT, one must remember the correct insight underlying the
CAPM: The only risk that investors should be compensated
for bearing is the risk that cannot be diversified away. Only
systematic risk will command a risk premium. But the
systematic elements of risk in particular stocks and portfolios
may be too complicated to be captured by beta—the
tendency of the stocks to move more or less than the market.
This is especially so because any particular stock index is an
imperfect representative of the general market. Hence, beta
may fail to capture a number of important systematic
elements of risk.
Let’s take a look at several of these other systematic risk
elements. Changes in national income undoubtedly affect

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returns from individual stocks in a systematic way. This was
shown in our illustration of a simple island economy in
chapter 8. Also, changes in national income mirror changes in
the personal income of individuals, and the systematic
relationship between security returns and salary income can
be expected to have a significant effect on individual behavior.
For example, the laborer in a Ford plant will find holding Ford
common stock particularly risky, because job layoffs and
poor returns from Ford stock are likely to occur at the same
time. Changes in national income may also reflect changes in
other forms of property income and may, therefore, be
relevant for institutional portfolio managers as well.
Changes in interest rates also systematically affect the
returns from individual stocks and are important
nondiversifiable risk elements. To the extent that stocks tend
to suffer as interest rates go up, equities are a risky
investment, and those stocks that are particularly vulnerable
to increases in the general level of interest rates are especially
risky. Thus, some stocks and fixed-income investments tend
to move in parallel, and these stocks will not be helpful in
reducing the risk of a bond portfolio. Because fixed-income
securities are a major part of the portfolios of many

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institutional investors, this systematic risk factor is