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    Arbitrage Pricing Theory

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    Paras Walia
    Arbitrage Pricing Theory (APT) is an alternative asset pricing model to the Capital Asset Pricing Model (CAPM). APT has three main assumptions and does not require that returns be normally distributed or that investors have a quadratic utility function like CAPM. APT models expected asset returns as a linear function of various macroeconomic factors rather than just the market portfolio. It allows for multiple factors like inflation and GDP growth to influence returns rather than just one market factor. The document provides an example of a two-factor APT model and the expected returns it generates for two stocks. It notes limitations of APT including that the relevant factors must be empirically determined and there is no guarantee all factors are identified

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    Arbitrage Pricing Theory

    Uploaded by

    Paras Walia
    122 views13 pages
    Arbitrage Pricing Theory (APT) is an alternative asset pricing model to the Capital Asset Pricing Model (CAPM). APT has three main assumptions and does not require that returns be normally distributed or that investors have a quadratic utility function like CAPM. APT models expected asset returns as a linear function of various macroeconomic factors rather than just the market portfolio. It allows for multiple factors like inflation and GDP growth to influence returns rather than just one market factor. The document provides an example of a two-factor APT model and the expected returns it generates for two stocks. It notes limitations of APT including that the relevant factors must be empirically determined and there is no guarantee all factors are identified

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    Arbitrage Pricing Theory (APT) is an alternative asset pricing model to the Capital Asset Pricing Model (CAPM). APT has three main assumptions and does not require that returns be normally distributed or that investors have a quadratic utility function like CAPM. APT models expected asset returns as a linear function of various macroeconomic factors rather than just the market portfolio. It allows for multiple factors like inflation and GDP growth to influence returns rather than just one market factor. The document provides an example of a two-factor APT model and the expected returns it generates for two stocks. It notes limitations of APT including that the relevant factors must be empirically determined and there is no guarantee all factors are identified

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    122 views13 pages

    Arbitrage Pricing Theory

    Uploaded by

    Paras Walia
    Arbitrage Pricing Theory (APT) is an alternative asset pricing model to the Capital Asset Pricing Model (CAPM). APT has three main assumptions and does not require that returns be normally distributed or that investors have a quadratic utility function like CAPM. APT models expected asset returns as a linear function of various macroeconomic factors rather than just the market portfolio. It allows for multiple factors like inflation and GDP growth to influence returns rather than just one market factor. The document provides an example of a two-factor APT model and the expected returns it generates for two stocks. It notes limitations of APT including that the relevant factors must be empirically determined and there is no guarantee all factors are identified

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 13

    Arbitrage Pricing Theory

    Submitted by - Paras Walia Roll no. 1273595 MBA 3rd (F2)

    Arbitrage Pricing Theory (APT)


    CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark An alternative pricing theory with fewer assumptions was developed: Arbitrage Pricing Theory

    Arbitrage Pricing Theory - APT


    Three major assumptions: 1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty 3. The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or indexes

    Assumptions of CAPM That Were Not Required by APT


    APT does not assume A market portfolio that contains all risky assets, and is mean-variance efficient Normally distributed security returns Quadratic utility function

    Arbitrage Pricing Theory (APT)


    Rt Rf bi1 f i bi 2 f 2 ... bik f k i
    Rit is the required rate of return for security i at t time period. Rf is Risk Free Rate of Return f is a factor is a relationship between security price and its factor.

    Arbitrage Pricing Theory (APT)


    CAPM has only one single non company factor and a single beta In APT, there are basically two factors company and non company based. Each factor has one beta

    Arbitrage Pricing Theory (APT)

    Ei 0 1bi1 2bi 2 ... k bik


    where: 0= the expected return on an asset with zero systematic risk where 0 0 1= the risk premium related to each of the common factors - for example the risk premium related to interest rate risk 1 i 0 bi = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor K

    E E

    in the rate of inflation. The risk premium 1= changes related to this factor is 1 percent for every 1 percent
    change in the rate

    Example of Two Stocks and a Two-Factor Model

    (1 .01)

    growth in real GNP. The average risk premium 2= percent related to this factor is 2 percent for every 1 percent
    change in the rate

    (2 .02)

    rate of return on a zero-systematic-risk asset (zero 3= the beta: b =0) is 3 percent


    oj

    (3 .03)

    Example of Two Stocks and a Two-Factor Model

    bx1= the response of asset X to changes in the rate of inflation


    is 0.50

    (bx1 .50)

    by1= the response of asset Y to changes in the rate of inflation


    is 2.00

    (by1 .50)

    bx 2 = the response of asset X to changes in the growth rate of


    real GNP is 1.50

    (bx 2 1.50)

    b y 2= the response of asset Y to changes in the growth rate of


    real GNP is 1.75

    (by 2 1.75)

    Ei 0 1bi1 2bi 2

    Example of Two Stocks and a Two-Factor Model

    = .03 + (.01)bi1 + (.02)bi2 Ex = .03 + (.01)(0.50) + (.02)(1.50) = .065 = 6.5% Ey = .03 + (.01)(2.00) + (.02)(1.75) = .085 = 8.5%

    Arbitrage Pricing Theory (APT)


    The problem with this is that the theory in itself provides no indication of what these factors are, so they need to be empirically determined. The potentially large number of factors means more betas to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM.

    Roll-Ross Study
    The methodology used in the study is as follows: 1. Estimate the expected returns and the factor coefficients from time-series data on individual asset returns 2. Use these estimates to test the basic crosssectional pricing conclusion implied by the APT The authors concluded that the evidence generally supported the APT, but acknowledged that their tests were not conclusive

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