DOW Theory

Dow Theory is a set of principles for analyzing stock market movements developed by Charles
Dow, co-founder of Dow Jones & Company and the first editor of The Wall Street Journal. This
theory is based on Dow’s editorials and was later formalized by William Hamilton and Robert
Rhea. Dow Theory suggests that the stock market moves in identifiable long-term trends which
are confirmed by the performance of the Dow Jones Industrial and Dow Jones Transportation
averages. It outlines three primary movements: the main movement (major trend), the medium
swing (secondary reaction), and the short movement (daily fluctuations). Dow Theory also
emphasizes that volume should confirm trends, with volume increasing in the direction of the
primary trend. It remains a foundational concept for modern technical analysis, helping investors
to predict potential market trends based on historical price movements.

Dow Theory Principles:

Dow Theory, developed from the writings of Charles Dow, founder of The Wall Street Journal
and co-founder of Dow Jones & Company, offers a framework for technical analysis and a
method for studying market movements.

1. The Market Has Three Movements:

o Primary movements are major trends that last a year or more and represent the
broad underlying market direction.
o Secondary movements are corrective phases within the primary trend, lasting
from a few weeks to a few months.
o Minor movements are short-term fluctuations that are often just noise within the
secondary movements.
2. Market Trends Have Three Phases:
o Accumulation Phase: The knowledgeable investors start buying or selling,
anticipating new market directions.
o Public Participation Phase: The majority of investors catch on and begin
following the new trend.
o Distribution Phase: Knowledgeable investors start to close their positions as the
market peaks or bottoms out.
3. The Stock Market Discounts All News:

Stock prices quickly incorporate and reflect all available information, meaning the market price
is influenced by future expectations and all known information.

4. Indexes Must Confirm Each Other:

For a trend to be established, major indexes, particularly industrials and transports as per Dow’s
time, must confirm each other. For example, if one index reaches a new high or low, the other
must soon follow for a true trend confirmation.
 5. Volume Must Confirm the Trend:

Volume should increase when the price moves in the direction of the trend and decrease during
counter-trend moves. This serves as a confirmation that the prevailing trend is supported by the
market.

6. Trends Continue Until Definitive Signals Prove That They Have Ended:

Trend in motion is presumed to be in effect until clear and definitive signals prove that it has
reversed. This principle underscores the importance of staying with the trend until significant
evidence suggests it has ended.

Failure Swing

The failure of the peak at C to overcome A, followed by the violation of the low at B, constitutes
a “sell” signal at S.

Nonfailure Swing

Notice that C exceeds A before D falling below B. Some Dow theorists would see a “sell” signal
at S1, while others would need to see a lower high at E before turning bearish at S2.
Dow only took in consideration closing prices. Averages had to close higher than a previous
peak or lower than a previous trough to be significant. Intraday penetrations did not count.

Failure Swing Bottom

The “buy” signal takes place when point B is exceeded (at Bl).

Nonfailure Swing Bottom

“Buy” signals occur at points B1 or B2.

Trend Line

In finance, a trend line is a bounding line for the price movement of a security. It is formed
when a diagonal line can be drawn between a minimum of three or more price pivot points. A
line can be drawn between any two points, but it does not qualify as a trend line until tested.
Hence the need for the third point, the test. Trend lines are commonly used to decide entry and
exit timing when trading securities. They can also be referred to as a Dutch line, as the concept
was first used in Holland.

A support trend line is formed when a securities price decreases and then rebounds at a pivot
point that aligns with at least two previous support pivot points. Similarly a resistance trend
line is formed when a securities price increases and then rebounds at a pivot point that aligns
with at least two previous resistance pivot points. Stock often begin or end trending because of
a stock catalyst such as a product launch or change in management.

Trend lines are a simple and widely used technical analysis approach to judging entry and exit
investment timing. To establish a trend line historical data, typically presented in the format of a
chart such as the above price chart, is required. Historically, trend lines have been drawn by hand
on paper charts, but it is now more common to use charting software that enables trend lines to
be drawn on computer based charts. There are some charting software that will automatically
generate trend lines, however most traders prefer to draw their own trend lines.

When establishing trend lines it is important to choose a chart based on a price interval period
that aligns with your trading strategy. Short term traders tend to use charts based on interval
periods, such as 1 minute (i.e. the price of the security is plotted on the chart every 1 minute),
with longer term traders using price charts based on hourly, daily, weekly and monthly interval
periods.

However, time periods can also be viewed in terms of years. For example, below is a chart of
the S&P 500 since the earliest data point until April 2008. While the Oracle example above uses
a linear scale of price changes, long term data is more often viewed as logarithmic: e.g. the
changes are really an attempt to approximate percentage changes than pure numerical value.

Trend lines are typically used with price charts, however they can also be used with a range
of technical analysis charts such as MACD and RSI. Trend lines can be used to identify positive
and negative trending charts, whereby a positive trending chart forms an upsloping line when the
support and the resistance pivots points are aligned, and a negative trending chart forms a
downsloping line when the support and resistance pivot points are aligned.

Trend lines are used in many ways by traders. If a stock price is moving between support and
resistance trend lines, then a basic investment strategy commonly used by traders, is to buy a
stock at support and sell at resistance, then short at resistance and cover the short at support. The
logic behind this, is that when the price returns to an existing principal trend line it may be an
opportunity to open new positions in the direction of the trend, in the belief that the trend line
will hold and the trend will continue further. A second way is that when price action breaks
through the principal trend line of an existing trend, it is evidence that the trend may be going to
fail, and a trader may consider trading in the opposite direction to the existing trend, or exiting
positions in the direction of the trend.

Gap Wave Theory

Gaps occur because of underlying fundamental or technical factors. For example, if a
company’s earnings are much higher than expected, the company’s stock may gap up the next
day. This means the stock price opened higher than it closed the day before, thereby leaving a
gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens
the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking
a new high in the current session may open higher in the next session, thus gapping up for
technical reasons.

Gaps can be classified into four groups:

 Breakaway gaps occur at the end of a price pattern and signal the beginning of a new
trend.
  Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit
new highs or lows.
 Common gaps cannot be placed in a price pattern – they simply represent an area where
the price has gapped.
 Continuation gaps, also known as runaway gaps, occur in the middle of a price pattern
and signal a rush of buyers or sellers who share a common belief in the underlying
stock’s future direction.

To Fill or Not to Fill

When someone says a gap has been filled, that means the price has moved back to the original
pre-gap level. These fills are quite common and occur because of the following:

 Irrational exuberance: The initial spike may have been overly optimistic or pessimistic,
therefore inviting a correction.
 Technical resistance: When a price moves up or down sharply, it doesn’t leave behind
any support or resistance.
 Price Pattern: Price patterns are used to classify gaps and can tell you if a gap will be
filled or not. Exhaustion gaps are typically the most likely to be filled because they signal
the end of a price trend, while continuation and breakaway gaps are significantly less
likely to be filled since they are used to confirm the direction of the current trend.

When gaps are filled within the same trading day on which they occur, this is referred to
as fading. For example, let’s say a company announces great earnings per share for this
quarter and it gaps up at the open (meaning it opened significantly higher than its previous
close). Now let’s say, as the day progresses, people realize that the cash flow statement shows
some weaknesses, so they start selling. Eventually, the price hits yesterday’s close, and the gap is
filled. Many day traders use this strategy during earnings season or at other times when irrational
exuberance is at a high.

How to Play the Gaps

There are many ways to take advantage of these gaps, with a few strategies more popular than
others. Some traders will buy when fundamental or technical factors favor a gap on the next
trading day. For example, they’ll buy a stock after hours when a positive earnings report is
released, hoping for a gap up on the following trading day. Traders might also buy or sell into
highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill
and a continued trend. For example, they may buy a currency when it is gapping up very quickly
on low liquidity and there is no significant resistance overhead.

Some traders will fade gaps in the opposite direction once a high or low point has been
determined (often through other forms of technical analysis). For example, if a stock gaps up on
some speculative report, experienced traders may fade the gap by shorting the stock. Lastly,
traders might buy when the price level reaches the prior support after the gap has been filled. An
example of this strategy is outlined below.
Here are the key things you will want to remember when trading gaps:

 Once a stock has started to fill the gap, it will rarely stop, because there is often no
immediate support or resistance.
 Exhaustion gaps and continuation gaps predict the price moving in two different
directions – be sure you correctly classify the gap you are going to play.
 Retail investors are the ones who usually exhibit irrational exuberance;
however, institutional investors may play along to help their portfolios, so be careful
when using this indicator and wait for the price to start to break before taking a position.
 Be sure to watch the volume. High volume should be present in breakaway gaps, while
low volume should occur in exhaustion gaps.

TAKEAWAYS

 Gaps are spaces on a chart that emerge when the price of the financial instrument
significantly changes with little or no trading in-between.
 Gaps occur unexpectedly as the perceived value of the investment changes, due to
underlying fundamental or technical factors.
 Gaps are classified as breakaway, exhaustion, common, or continuation, based on when
they occur in a price pattern and what they signal.

Technical Versus Fundamental Analysis

Fundamental analysis and technical analysis, the major schools of thought when it comes to
approaching the markets, are at opposite ends of the spectrum. Both methods are used for
researching and forecasting future trends in stock prices, and, like any investment strategy or
philosophy, both have their advocates and adversaries.

Fundamental Analysis

Fundamental analysis is a method of evaluating securities by attempting to measure the intrinsic

value of a stock. Fundamental analysts study everything from the overall economy and industry
conditions to the financial condition and management of companies. Earnings, expenses, assets,
and liabilities are all important characteristics to fundamental analysts.

Technical Analysis

Technical analysis differs from fundamental analysis in that the stock’s price and volume are the
only inputs. The core assumption is that all known fundamentals are factored into price, thus
there is no need to pay close attention to them. Technical analysts do not attempt to measure a
security’s intrinsic value, but, instead, use stock charts to identify patterns and trends that suggest
what a stock will do in the future.
The most popular forms of technical analysis are simple moving averages, support and
resistance, trend lines, and momentum-based indicators.

Fundamental analysis and technical analysis are the major schools of thought when it comes to
approaching the markets.

Simple Moving Averages

Simple moving averages are indicators that help assess the stock’s trend by averaging the daily
price over a fixed period. Buy and sell signals are generated when a shorter duration moving
average crosses a longer duration one.

Support and resistance utilize price history. Support is defined as areas where buyers have
stepped in before, while resistance consists of the areas where sellers have impeded price
advance. Practitioners look to buy at support and sell at resistance.

Trend lines are similar to support and resistance, as they give defined entry and exit points.
However, they differ in that they are projections based on how the stock has traded in the past.
They are often utilized for stocks moving to new highs or new lows where there is no price
history.

There are a number of momentum-based indicators, such as Bollinger Bands®, Chaikin Money
Flow, stochastics, and moving average convergence/divergence(MACD). These each have
unique formulas and give buy and sell signals based on varying criteria. Momentum indicators
tend to be used in range-bound or trendless markets.

 Fundamental analysis is a method of evaluating securities by attempting to measure the

intrinsic value of a stock.
 Technical analysis differs from fundamental analysis in that the stock’s price and volume
are the only inputs.
 Both methods are used for researching and forecasting future trends in stock prices.

Capital Market Theorem

Capital Market Theory tries to explain and predict the progression of capital (and sometimes
financial) markets over time on the basis of the one or the other mathematical model. Capital
market theory is a generic term for the analysis of securities.

In terms of tradeoff between the returns sought by investors and the inherent risks involved, the
capital market theory is a model that seeks to price assets, most commonly, shares.
In general, whenever someone tries to formulate a financial, investment, or retirement plan, he or
she (consciously or unconsciously) employs a theory such as arbitrage pricing theory, capital
asset pricing model, coherent market hypothesis, efficient market hypothesis, fractal market
hypothesis, or modern portfolio theory.

The most talked about model in Capital Market Theory is the Capital Asset Pricing Model.

In studying the capital market theory we deal with issues like the role of the capital markets, the
major capital markets in the US, the initial public offerings and the role of the venture capital in
capital markets, financial innovation and markets in derivative instruments, the role of securities
and the exchange commission, the role of the federal reserve system, role of the US Treasury and
the regulatory requirements on the capital market.

Capital Market Theory sets the environment in which securities analysis is preformed. Without a
well-constructed view of modem capital markets, securities analysis may be a futile activity. A
great debate, and great divide, separates the academics, with their efficient market hypothesis,
and the practitioners, with their views of market inefficiency. Although the debate appears
surreal and unimportant at times, its resolution is immensely critical for conducting effective
securities analysis and investing successfully.

The CAPM is commonly confused with portfolio theory. Portfolio theory is simply the use of
statistical and mathematical programming techniques to derive optimal tradeoffs between risk
and return. Under very restrictive assumptions (rarely found in financial markets), the CAPM is a
highly specialized subset of portfolio theory. Even so, the CAPM has become very popular as it
provides a logical, common sense tradeoff between risk and return.
Risk-free Asset

Risk-free asset is an asset, which has a certain future return. In other words, a risk-free asset is
one for which there is no uncertainty regarding the future returns; that is, the investor knows
exactly what the value of the asset will be at the end of the holding period. Thus, variance of
returns of a risk-free asset is equal to zero. A good example of such asset is government bonds.

Risk-Free Lending and Borrowing:

Investing in a risk-free asset is frequently referred to as `risk-free lending’, since investment in

such assets tantamount to giving loan directly to the government. An investor does not have to
depend solely on his own wealth to decide how much to invest in assets. She/he can borrow and
invest, i.e., the investor can use financial leverage. However, investor will have to pay interest on
borrowed funds and such borrowing is also assumed to have same risk-free interest rate and
hence deemed as “risk-free borrowing”. Though it may not be practical for an ordinary investor
to borrow at risk-free interest rate, it is quiet possible for large funds to borrow at a rate close to
risk-free rate.
The risk-free rate is assumed to be 5%, and a tangent line-called the capital market line-has been
drawn to the efficient frontier passing through the risk-free rate. The point of tangency
corresponds to a portfolio on the efficient frontier. That portfolio is called the “super-efficient”
portfolio. The Capital Asset Pricing Model demonstrates that, given certain simplifying
assumptions, the super-efficient portfolio must be the market portfolio.

Using the risk-free asset, investors who hold the super-efficient portfolio may:

 Leverage their position by shorting the risk-free asset and investing the proceeds in
additional holdings in the super-efficient portfolio.
 Deleverage their position by selling some of their holdings in the superefficient portfolio
and investing the proceeds in the risk-free asset.

Issues of Capital Market Theory:

 Importance of venture capital in the capital market

 Initial public offerings
 Role of capital market
 Major capital markets worldwide
 Markets and financial innovations in derivative instruments
 Role of Federal Reserve System
 Role of securities
 Capital market regulatory requirements
 Role of the government treasury
Capital Asset Pricing Model, Assumptions,
Importance

Capital Asset Pricing Model (CAPM) is a model that describes the relationship between
expected return and risk of investing in a security. It shows that the expected return on a security
is equal to the risk-free return plus a risk premium, which is based on the beta of that security.
Below is an illustration of the CAPM concept.

CAPM Formula and Calculation

Ra = Rrf + [Ba*(Rm – Rrf)]

Where:

Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market

Note: “Risk Premium” = (Rm – Rrf)

CAPM formula is used to calculate the expected return on investable asset. It is based on the
premise that investors have assumptions of systematic risk (also known as market risk or non-
diversifiable risk) and need to be compensated for it in the form of a risk premium – an amount
of market return greater than the risk-free rate. By investing in a security, investors want a higher
return for taking on additional risk.
  Expected Return

The “Ra” notation above represents the expected return of a capital asset over time, given all of
the other variables in the equation. The expected return is a long-term assumption about how an
investment will play out over its entire life.

 Risk-Free Rate

The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-year
US government bond. The risk-free rate should correspond to the country where the investment
is being made, and the maturity of the bond should match the time horizon of the investment.
Professional convention, however, is to typically use the 10-year rate no matter what, because
it’s the most heavily quoted and most liquid bond.

The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall market.
In other words, it is the stock’s sensitivity to market risk. For instance, if a company’s beta is
equal to 1.5 the security has 150% of the volatility of returns of the market average. However, if
the beta is equal to 1, the expected return on a security is equal to the average market return. A
beta of -1 means security has a perfect negative correlation with the market.
  Market Risk Premium

From the above components of CAPM we can simplify the formula to reduce “expected return of
the market minus the risk-free rate” to be simply the “market risk premium”. The market risk
premium represents the additional return over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class. Put another way, the more volatile a
market or an asset class is, the higher the market risk premium will be.

CAPM Assumptions:

1. Risk-Free Asset

CAPM assumes the existence of a risk-free asset, meaning an asset that has a guaranteed return
with no risk of financial loss. Investors can borrow or lend unlimited amounts at the risk-free
rate.

2. Single-Period Model

CAPM is a single-period model, assuming that investors have identical investment horizons
typically over a single time period. This simplification disregards the effects of multi-period
investment strategies and lifecycle investment considerations.

3. Markets are Perfectly Competitive and Efficient

The model assumes that all securities are perfectly divisible and that markets are frictionless—no
transaction costs, taxes, or restrictions on short selling exist. It also assumes all information is
available to all investors simultaneously and accurately, leading to securities always being fairly
priced (market efficiency).

4. Homogeneous Expectations

All investors have the same expectations regarding the volatilities, correlations, and expected
returns of investment portfolios. This assumption simplifies the analysis by ensuring that all
investors agree on the risk and return of all securities.

5. Investors are Rational and Risk-Averse

CAPM assumes that investors are rational, meaning they will always choose more wealth over
less and prefer more return for less risk. Investors are risk-averse, meaning they need to be
compensated for taking on additional risk, and will always choose the portfolio with the highest
expected utility.

6. Investors Hold Diversified Portfolios

The model presupposes that all investors hold diversified portfolios that approximate the market
portfolio. This “market portfolio” contains all assets in the market, with each asset weighted by
its market capitalization. The diversification effectively eliminates unsystematic risk (specific to
individual securities).

7. Only Systematic Risk Matters

CAPM contends that the only risk priced by the market is systematic risk, as represented by the
beta (β) of a security. Systematic risk is inherent to the entire market and cannot be eliminated
through diversification. Unsystematic risk, which is specific to individual securities or industries,
is assumed to be diversified away.

8. Unlimited Borrowing and Lending

Investors can borrow and lend unlimited amounts at the risk-free rate. This assumption is crucial
for the construction of the Capital Market Line (CML), where all investors will choose a
combination of the risk-free asset and the market portfolio.

CAPM Importance:

1. Risk-Return Tradeoff Understanding

CAPM provides a clear and quantifiable relationship between the expected return of a security
and its risk, as measured by beta (β). This model highlights the linear relationship where the
expected return on a security is equal to the risk-free rate plus the risk premium. This risk
premium is determined by the security’s sensitivity to market movements (beta) and the market’s
overall risk premium.

2. Portfolio Diversification

CAPM underscores the benefits of diversification, focusing only on the systematic risk of a
security or a portfolio (i.e., risk that cannot be diversified away). It suggests that the only type of
risk for which investors should receive an expected return is the risk that cannot be eliminated
through diversification. This principle guides investors on how to effectively diversify their
portfolios to minimize unsystematic risk.

3. Security Valuation

The model is widely used for asset pricing – helping to determine what an investment should be
worth based on its risk. It’s particularly useful in the valuation of stocks, where the expected
return as determined by CAPM is used as the discount rate for valuing a company’s future cash
flows in the discounted cash flow (DCF) analysis.

4. Performance Evaluation

CAPM helps in evaluating the performance of portfolios or individual securities by providing a

benchmark return that should be achieved given the level of risk assumed. If the actual returns
exceed the CAPM return, the investment is considered to have generated positive alpha,
indicating superior performance adjusted for risk.

5. Cost of Capital

Businesses use CAPM to estimate their cost of equity. This is crucial for making decisions about
capital structure, such as determining the appropriate mix of debt and equity financing. The cost
of equity calculated through CAPM is used to assess the weighted average cost of capital
(WACC), a key factor in capital budgeting decisions and corporate finance.

6. Strategic Decision Making

Companies can apply the insights from CAPM for strategic decisions such as expansion,
mergers, acquisitions, and other investment opportunities. By understanding the required return
for taking on additional risk, managers can make more informed decisions that align with
shareholder value maximization.

7. Regulatory Use

Regulators may use CAPM to set required rates of return for utility companies or to assess the
fairness of returns given the risk levels of regulated firms, ensuring that these companies do not
charge excessive prices or take on excessive risk at the expense of consumers.

8. Investment Strategy

Investment advisors and financial planners use CAPM to tailor investment strategies according
to individual risk profiles, helping clients achieve optimal returns for their specific levels of risk
tolerance.

9. Educational Framework

In academia, CAPM is a standard teaching tool that introduces students to the concepts of
systematic risk, risk-return tradeoff, and market efficiency, forming the backbone of many
finance courses.

Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT), developed by economist Stephen Ross in 1976, is a multi-
factor asset pricing model that explains the expected return of a financial asset through a linear
relationship with various macroeconomic factors or theoretical market indices. Unlike the
Capital Asset Pricing Model (CAPM), which relies on a single market risk factor (beta), APT
allows for multiple factors, such as inflation, interest rates, and GDP growth, to influence an
asset’s return. APT assumes that if the actual return deviates from the expected return predicted
by the model, arbitrage opportunities will arise, leading investors to exploit these discrepancies
until prices adjust and the arbitrage opportunities disappear, restoring market equilibrium.

Assumptions in the Arbitrage Pricing Theory:

1. Factor Structure of Returns:

APT assumes that asset returns can be described by a linear function of multiple macroeconomic
factors or market indices. Each asset’s return is influenced by a specific set of factors, with each
factor contributing to the asset’s overall return.

2. No Arbitrage Condition:

The theory assumes that there are no opportunities for arbitrage (risk-free profit) in well-
functioning markets. If arbitrage opportunities exist, they will be quickly exploited by investors,
causing prices to adjust until the opportunities are eliminated.

3. Perfect Capital Markets:

APT assumes that markets are perfect, meaning there are no transaction costs, taxes, or
restrictions on short selling. Investors can borrow and lend at a risk-free rate.

4. Homogeneous Expectations:

Investors are assumed to have homogeneous expectations, meaning they all agree on the factor
structure and the expected returns associated with each factor.

5. Sufficient Number of Securities:

The model assumes there is a large number of securities in the market, allowing for sufficient
diversification. This diversification enables investors to eliminate unsystematic risk (specific to
individual assets) by holding a well-diversified portfolio.

6. Factor Independence:

The factors influencing asset returns are assumed to be independent of each other. This
independence ensures that the risk associated with each factor is distinct and does not overlap
with others.

Arbitrage in the APT:

Arbitrage in the context of the Arbitrage Pricing Theory (APT) refers to the practice of
exploiting price discrepancies between assets that should, theoretically, offer the same returns
based on the model’s assumptions. APT suggests that the expected return on an asset is a linear
function of various macroeconomic factors or market indices. When the actual price of an asset
deviates from the price predicted by the APT model, an arbitrage opportunity arises.
 1. Identifying Mispriced Assets:

According to APT, if an asset’s actual return deviates from its expected return, given its
exposure to certain risk factors, the asset is considered mispriced. This discrepancy can occur
due to market inefficiencies, incorrect factor exposures, or temporary market anomalies.

2. Arbitrage Opportunity:

Arbitrageurs (traders who exploit these price discrepancies) will take advantage of the mispricing
by creating a portfolio of assets that mimics the factor sensitivities of the mispriced asset but at a
different (correct) price.

For example, if the asset is underpriced according to APT, arbitrageurs would buy the asset and
simultaneously short-sell a correctly priced portfolio with the same factor sensitivities.
Conversely, if the asset is overpriced, they would sell it and buy the correctly priced portfolio.

3. Restoring Equilibrium:

The actions of arbitrageurs (buying underpriced assets and selling overpriced ones) will push the
prices toward their equilibrium levels, where the actual returns align with the returns predicted
by the APT model. This process eliminates the arbitrage opportunity and ensures that the market
prices reflect the underlying risk factors accurately.

4. No Arbitrage Condition:

APT is based on the principle that in efficient markets, arbitrage opportunities are quickly
eliminated, leading to a situation where no risk-free profits can be made. This no-arbitrage
condition ensures that the expected returns of assets, given their risk factor exposures, are
correctly priced in the market.

Mathematical Model of the APT:

The Arbitrage Pricing Theory can be expressed as a mathematical model:

Where:

E(rj) – Expected return on asset

rf – Risk-free rate

ßn – Sensitivity of the asset price to macroeconomic factor n

RPn – Risk premium associated with factor n

The beta coefficients in the APT are estimated by using linear regression. In general, historical
securities returns are regressed on the factor to estimate its beta.

Factors in the APT:

1. Inflation:

Inflation affects the purchasing power of money and can impact interest rates, consumer
spending, and corporate profits. Changes in inflation rates can therefore influence the returns of
securities, especially bonds and stocks sensitive to inflationary pressures.

2. Interest Rates:

Interest rate changes, typically driven by central bank policies, affect the cost of borrowing and
the discount rate applied to future cash flows. Securities such as bonds and interest-sensitive
stocks (e.g., utilities, financials) are particularly impacted by changes in interest rates.

3. Gross Domestic Product (GDP) Growth:

Economic growth, as measured by GDP, influences corporate earnings and overall market
sentiment. Strong GDP growth generally boosts business profits, leading to higher stock returns,
while a slowing economy can have the opposite effect.

4. Market Index Returns:

A broad market index, such as the S&P 500, captures the overall movement of the stock market.
The performance of this index can be a factor in APT, reflecting the general trend of the equity
market.

5. Exchange Rates:

Fluctuations in exchange rates affect companies that have significant operations or sales
overseas. A stronger domestic currency can reduce the value of foreign earnings when converted
back to the home currency, impacting the returns of multinational companies.

6. Commodity Prices:

Prices of key commodities like oil, gold, and other raw materials can influence the profitability
of companies involved in production, transportation, or consumption of these resources. For
instance, rising oil prices typically benefit energy companies but hurt airlines.

7. Default Risk (Credit Risk):

The risk that a company or government will fail to meet its debt obligations can affect bond
prices and yields. Higher perceived default risk leads to higher yields on bonds, reflecting the
increased risk premium demanded by investors.

Selection of Factors:

 Empirical Identification:

Unlike CAPM, APT does not specify a fixed set of factors. The choice of factors is empirical and
can vary based on the specific market or set of securities being analyzed. Researchers and
analysts use statistical techniques such as factor analysis or principal component analysis to
identify the most relevant factors that explain the variability in asset returns.

 Relevance to the Asset Class:

The factors chosen depend on the asset class and the economic environment. For example, in an
analysis of equities, factors like GDP growth and market index returns might be crucial, whereas,
for bonds, interest rates and inflation might be more relevant.