By MEHRAN MBA 4th Semester Group B

Arbitrage Means

The simultaneous purchase and sale of an asset in order to profit from a difference in the price.

It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

Arbitrage Pricing Theory

Arbitrage Pricing Theory was developed by Stephen Ross (1976). APT assumes that investors are fully diversified and the systematic risk is an influencing factor in the long run

APT specifies a simple linear relationship between asset returns and the associated factors

Arbitrage pricing theory (APT) states that a number of distinct factors determine the market return
Roll and Ross state that a securitys long-run return is a function of changes in: Inflation Industrial production Risk premiums Interest rates

Arbitrage Pricing Theory (APT)

Multiple factors expected to have an impact on all assets: Inflation Growth in GNP Major political upheavals Changes in interest rates

APT contd
Three major assumptions: Capital markets are perfectly competitive Investors always prefer more wealth to less wealth with certainty Generating asset returns can be expressed as a linear function of a set of K factors

MULTIPLE-FACTOR MODELS
FORMULA

ri = ai + bi1 F1 + bi2 F2 +. . .
+ biKF K+ ei
where r is the return on security i b is the coefficient of the factor F is the factor e is the error term

SECURITY PRICING
FORMULA:

ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK where ri = rRF +(d1-rRF )bi1 + (d2- rRF)bi2+ . . . +(d-rRF)biK

where r l0 b e is the return on security i is the risk free rate is the factor is the error term

The APT Model

General representation of the APT model:

RA E ( RA ) + b1 A F1 + b2 A F2 + b3 A F3 + b4 A F4 where RA actual return on Security A E ( RA ) expected return on Security A biA sensitivity of Security A to factor i Fi unanticipated change in factor i

Arbitrage Pricing Theorybriefly

Arbitrage - arises if an investor can construct a

zero investment portfolio with a sure profit

Since no investment is required, an investor can create large positions to secure large levels of profit

In efficient markets, profitable opportunities will quickly disappear

arbitrage