Investments, tenth edition

  THE EXPLOITATION OF 

security  mispricing in 

such a way that risk-free profits can be earned 

is called arbitrage. It involves the simultane-

ous purchase and sale of equivalent securi-

ties in order to profit from discrepancies in 

their prices. Perhaps the most basic principle 

of capital market theory is that equilibrium 

market prices are rational in that they rule 

out arbitrage opportunities. If actual secu-

rity prices allow for arbitrage, the result will 

be strong pressure to restore equilibrium. 

Therefore, security markets ought to satisfy 

a “no-arbitrage condition.” In this chapter, 

we show how such no-arbitrage conditions 

together with the factor model introduced in 

Chapter 8 allow us to generalize the security 

market line of the CAPM to gain richer insight 

into the risk–return relationship. 

 We begin by showing how the decompo-

sition of risk into market versus firm-specific 

influences that we introduced in earlier 

 chapters can be extended to deal with the 

multifaceted nature of systematic risk. Mul-

tifactor models of security returns can be 

used to measure and manage exposure to 

each of many economywide factors such as 

business-cycle risk, interest or inflation rate 

risk, energy price risk, and so on. These models 

also lead us to a multifactor version of the 

security market line in which risk premiums 

derive from exposure to multiple risk sources, 

each with their own risk premium. 

 We show how factor models combined 

with a no-arbitrage condition lead to a simple 

relationship between expected return and 

risk. This approach to the risk–return trade-

off is called arbitrage pricing theory, or APT. 

In a single-factor market where there are no 

extra-market risk factors, the APT leads to a 

mean return–beta equation identical to that 

of the CAPM. In a multifactor market with 

one or more extra-market risk factors, the 

APT delivers a mean-beta equation similar 

to Merton’s intertemporal extension of the 

CAPM (his ICAPM). We ask next what factors 

are likely to be the most important sources 

of risk. These will be the factors generating 

substantial hedging demands that brought 

us to the multifactor CAPM introduced in 

Chapter 9. Both the APT and the CAPM there-

fore can lead to multiple-risk versions of the 

security market line, thereby enriching the 

insights we can derive about the risk–return 

relationship.  

   CHAPTER TEN