Scribd
Upload
91 views

Arbitrage Pricing Theory

The document provides an overview of arbitrage pricing theory (APT). It discusses: 1) APT is an alternative asset pricing model to the capital asset pricing model (CAPM) that explains asset prices based on multiple factors rather than just systematic risk. 2) APT is based on the idea that no riskless profit opportunities should exist in an efficient market, as arbitrageurs would eliminate any profit opportunities. 3) The APT model assumes asset returns are generated by a factor model relating the expected return of each asset to various macroeconomic factors. The factors must have an influence on many assets' returns.

Uploaded by

Sowmiya
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
91 views

Arbitrage Pricing Theory

The document provides an overview of arbitrage pricing theory (APT). It discusses: 1) APT is an alternative asset pricing model to the capital asset pricing model (CAPM) that explains asset prices based on multiple factors rather than just systematic risk. 2) APT is based on the idea that no riskless profit opportunities should exist in an efficient market, as arbitrageurs would eliminate any profit opportunities. 3) The APT model assumes asset returns are generated by a factor model relating the expected return of each asset to various macroeconomic factors. The factors must have an influence on many assets' returns.

Uploaded by

Sowmiya
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 18

ARBITRAGE PRICING THEORY

Introduction

 Arbitrage pricing theory(APT) is one of the tools used by investors and


portfolio managers
 Capital asset pricing theory explains the Returns of the securities on the
basic of their respective betas
 An investor choose investments on the basis of the expected return and
variance.
 The alternative model in asset pricing developed by Stephen Ross is
known as arbitrage pricing theory.
 APT explains the nature of equilibrium in asset pricing in a less
complicated manner with fewer assumptions than CAPM.
Arbitrage Pricing Theory(APT)

 What is APT based on?


It is a variant of the CAPM, and is an attempt to move away from the
mean-variance efficient portfolios
Ross instead calculated relationships among expected returns that
would rule out riskless profits by any investor in a well functioning capital
market
 What is it?
It is a another theory of risk and return similar to the CAPM.
It is based on the law of one price: two items that are the same can’t
sell at different prices
Arbitrage

 The process generates risk-free profit.

 The buying and selling activities of the arbitrager


reduce and eliminate the profit margin, bringing the
market price to the equilibrium level.
Arbitrage Pricing Theory

 Based on the Law of One Price


Since two otherwise identical assets cannot sell at different prices,
equilibrium prices adjust to eliminate all arbitrage opportunities
 Arbitrage opportunity
Arises if an investor can construct a zero investment portfolio with no risk but
with a positive profit
Since no investment is required, an investor can create large positions in long
and short to secure large levels of profits
 In an efficient market, profitable arbitrage opportunities will quickly disappear
APT Model

 APT assumes returns generated by a factor model


 Factor Characteristics
Each risk factor must have a pervasive influence on stock returns
Risk factor must have nonzero prices
Risk factor must be unpredictable to the market
 The expected return-risk relationship for the APT.
ASSUMPTIONS

 Investors have homogenous expectations

 They are risk averse and utility maximizers

 Perfect competition prevails in the market, and there is


no transaction cost.
APT and CAPM Compared

 APT applies to well diversified portfolios, and not necessarily to individual


stocks
With APT, it is possible for some individual stocks to be mispriced – not
lie on the SML
 APT is more general in that it gets to an expected return and beta
relationship without the assumption of the market portfolio
Unlike CAPM, APT does not assume mean-variance decisions, riskless
borrowing or lending, and existence of a market portfolio
 APT can be extended to multifactor models
APT and CAPM Compared

Difference:
 APT applies to well diversified portfolios and not necessarily to individual
stocks
 With APT it is possible for some individual stocks to be mispriced-to not on
the SML
 APT is more general in that it gets to an expected return and beta
relationship without the assumption of the market portfolio
 APT can be extended to multifactor model
Arbitrage portfolio

 According to APT, an investor tries to determine the


possibility of an increase in the returns from his portfolio
without increasing the funds in it.

 He also likes to keep the risk as the same level.


THE APT FORMULA

E(rj) = rf + bj2RP2 + bj3RP3 + ……… + bjnRPn

Where:

E(rj)=the asset’s expected rate of return


rf=the risk-free rate
bj=the sensitivity of the asset’s return to the particular factor
RP=the risk premium associated with the particular factor
APT Factor Models Approach

 Two-factor Model (actual return on a security)


Rj = a + b1jF1 + b2jF2 + ej
Where:
a=the return when all factors have zero values
Fn = the value (uncertain) of factor n
bnj = the reaction coefficient depicting the change in the security’s return to
a one-unit change in the factor
ej = the error term
Leeny Kelly Company’s stock is related to the following factors with respect
to actual return:
Rj = a + .8(F1) + 1.2(F2) + .3(F3) + ej
Suppose that the a term for the stock is 14 percent and that for the period
the unanticipated change in factor 1 is 5 percent, factor 2 is 2 percent, and
factor 3 is 10 percent. If the error term is zero, what would be the stock’s
actual return for the period?
Rj = a+.8(F1)+1.2(F2)+.3(F3)+ej
= .14+.8(.05) + 1.2(.02) + .3(.10) + 0
= 3.24%
APT Factor Models Approach

 Two-factor Model (expected return on a security)


(E)Rj = ^0+^1b1j+^2b2j
where:
^0 = corresponds to the return on a risk-free asset
^1 = the expected excess return (above the risk-free rate)
When:
b1j = 1 and b2j =0
Suppose Torquary Resorts Limited’s stock is related to two factors where the
reaction coefficients, b1j and b2j and 1.4 and .8, respectively. If the risk-free
rate is 8 percent, and ^1 is 6 percent and ^2 percent, the stock’s expected
return is:
(E)Rj = ^0 + ^1b1j + ^2b2j
(E)Rj = .8 + .06(1.4) - .02(.8) = 14.8%
The first factor reflects risk aversion and must be compensated for with a
higher expected return, whereas the second is a thing of value to investors
and lowers the return they expect. Thus, the ^’s represent market prices
associated with factor risks.
APT Factor Model Approach

 More that two factor Model (expected return)


(E)Rj = A + ^1b1j + ^2b2j + …..+ ^nbnj
Where:
^1 = represents the expected return in excess of the risk-free rate where
the reaction coefficient for the first factor,
b1j = is 1.0
Suppose return required in the market by investors are a function of two
factor according to the following equation, where the risk-free rate is 7
percent. Quigley Manufacturing Company and Zolotny Basic Products
Corporation both have the same reaction coefficients to the factors, such
that b1j = 1.3 and b2j = .9
(E)Rj = A +^1b1j + ^2b2j +……..+^nbnj
(E)Rj =.07 + .04(b1j) - .01(b2j)
=.07 + .04(1.3) - .01(9)
= 11.3%
THANK YOU

You might also like