UNIVERSITY

OF

JORDAN

ARBITRAGE THEORY

PRICING

A LITERATURE REVIEW
Submitted by: Diala Khawaldeh MBA-Management Student ID: 8090018 Subject: Instructor: Haddad Corporate Finance Dr. Fayez

Contents
Contents................................................................................................................. 2 Abstract.................................................................................................................. 3 Introduction............................................................................................................ 4 Literature review.................................................................................................... 6 Using the APT......................................................................................................... 9 Methodology.........................................................................................................10 References........................................................................................................... 11

Abstract
Arbitrage Pricing Theory, which we will be referring to as APT in this paper, is an asset pricing model based on the idea that an asset's returns can be predicted using the relationship between the asset and many common risk factors instead of one market factor as done in the Capital Asset Pricing Model (CAPM). Created in 1976 by Stephen Ross, this theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables systematic in nature. ATP and its extensions constitute an important branch of asset pricing theory and one of the primary alternatives to the Capital Asset Pricing Model (CAPM). In this paper, we will review some of the literature written on this theory, the concept behind it, and how to use it.

Introduction
Arbitrage pricing theory (APT), in Finance, is a general theory of asset pricing that has become popular in the pricing of shares and stocks based on the calculated expected returns. The theory was established by the Stephen Ross (economist) in 1976. APT states that the expected return of a financial asset is a linear function of various economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient. Once compared with the Capital Asset Pricing Model (CAPM), one difference is that it is less restrictive in its assumptions. That is, its more flexible in assumptions as it allows explanatory (instead of statistical) model of asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio" used in CAPM. Some think of the APT as an alternative for the Capital Asset Pricing Model (CAPM) in that both have a linear relation between assets expected returns and their covariance with other random variables. The covariance is interpreted as a measure of risk that investors cannot remove by diversification (Systematic risk). The slope coefficient in the linear relation between the expected returns and the covariance is interpreted as a risk premium. Risky asset returns are said to follow a factor structure if they can be expressed as:

where

E(rj) is the expected return of asset j Fk is a systematic factor (assumed to have mean zero), bjk is the sensitivity of the jth asset to factor k, also called factor loading, j is the risky asset's random shock (surprise) with mean zero.

The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:

We must keep in mind that here are some assumptions and requirements that have to be fulfilled for the equation above to be correct: There must be 1. perfect competition in the market
2.

the total number of factors may never exceed the total number of assets

Literature review
The Arbitrage Pricing Theory uses a factor model for asset returns to capture the intuition that there are many close substitutes in asset markets. The word "arbitrage" in the name comes from the limiting case in which there is no idiosyncratic noise. In this case, the linearity of expected returns in factor loadings is a direct consequence of the absence of arbitrage, since in this case portfolios with identical factor loadings are perfect substitutes. More generally, the APT follows in theoretical models with assumptions ensuring that portfolios with identical factor loadings are close substitutes. In his paper "A Comparison of CAPM & Arbitrage Pricing Theory", Rakesh Kumar presents some new evidence that Arbitrage Pricing Theory may lead to different and better estimates of expected return than the Capital Asset Pricing Model. By sampling the S&P CNX Nifty index for 60 months, and using the data for calculating expected returns using both CAPM and ATP, Rakesh has based his upon Connor's competitive equilibrium version of the APT and Ross's separating distribution. The derived results demonstrate that one need only add the market portfolio as an extra factor to the factor model in order to obtain an exact asset-pricing relation. If all factors are omitted, the new model reduces to the CAPM. When none of the factors is omitted, the new model becomes either the Ross APT in an infinite economy or the unified asset-pricing theory in a finite economy. [Kumar 2007] Handa and Linn has investigated the APT once used by investors having incomplete information on parameters generating asset return. Their paper's framework studies the estimates of factor betas for high and low information assets. Prices of riskiy assets and the factor betas were different from the complete information prices and betas. "When there is differential information, prices are relatively higher for high information assets as compared to the complete information case" [Handa and Linn 1993]

As for Capital Asset Pricing Model (CAPM), it is used in finance to determine a theoretically appropriate required rate of return (and thus the price if

expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's nondiversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. Arbitrage mechanics: In the APT context, arbitrage consists of trading in two assets with at least one being mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap. Under the APT, an asset is mispriced if its current price is different from the price predicted by the model. The asset price today should equal the sum of all future cash flows discounted at the APT rate, where the expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor is represented by a factor-specific beta coefficient. A correctly priced asset here may be in fact a synthetic asset (A portfolio consisting of other correctly priced assets). This portfolio has the same exposure to each of the systematic factors as the mispriced asset. The arbitrageur creates the portfolio by identifying X correctly priced assets (one per factor plus one) and then weighting the assets such that portfolio beta per factor is the same as for the mispriced asset. When the investor is long the asset and short the portfolio (or vice versa) he has created a position which has a positive expected return (the difference between asset return and portfolio return) and which has a netzero exposure to any macroeconomic factor and is therefore risk free. The arbitrageur is thus in a position to make a risk free profit: Where today's price is too low, then at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at more than this rate. The arbitrageur could do the following: Currently: 1. Short sells the portfolio 2. Buy the mispriced-asset with the proceeds. At the end of the period: 1. sell the mispriced asset 2. Use the proceeds to buy back the portfolio3 pocket the difference.

Based on the empirical evidence gathered so far, the APT cannot be rejected in favor of any alternative hypothesis, and the APT performs very well against the CAPM as Implemented by the S&P 500 (large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.), value weighted, and equally weighted indices. Therefore, the APT is a reasonable model for explaining crosssectional variation in asset returns. [Kumar 2007] In literature, several studies show that the competitive-equilibrium version of the APT may be extended to develop an exact model if surprising risks obey the Ross separating distribution. The results indicate that the investor only needs to add the market portfolio as an extra factor to the factor model in order to obtain an exact assetpricing relation. Thus, studies present an extension and integration of the CAPM and APT. The "empirical" APT is also generalized to allow for some factors to be omitted from the model employed to test the theory. The developed model is extremely robust and may be reduced to the CAPM or expanded to approximate Ross's APT depending upon the number of omitted factors. Further, the importance of the market portfolio is shown to be a monotonic increasing function of the number of omitted factors. Finally, literature demonstrates that, in a finite economy, the pricing-error bound of the APT in a correlated-returns factor structure is an increasing function of the absolute value of market-return beta, rather than the weight of the asset in the market portfolio as is the case of uncorrelated factor returns. However, under the normality assumption, the pricing error becomes an extra component related to the market-portfolio factor, and the exact asset-pricing relation is once again obtained. The Arbitrage Pricing Theory (APT) has been proposed as an alternative to the Mean variance Capital Asset Pricing Model (CAPM). Some part of the literature considers the testability of the APT and points out the irrelevance for testing of the approximation error. [Shanken 1982]

Using the APT

The first step in using the ATF is to identify the factors in the equation. As with the CAPM, the factor-specific betas are found via a linear regression of historical security returns on the factor in question. However, unlike the CAPM, in APT, the number and nature of priced factors is likely to change over time and between economies. As a result, this issue is essentially empirical (experimental) in nature. Several guidelines are suggested regarding the characteristics required of potential factors are:

their impact on asset prices manifests in their unexpected movements they should represent undiversifiable influences (these are more likely to be macroeconomic rather than firm-specific in nature) timely and accurate information on these variables is required the relationship should be theoretically justifiable on economic grounds

The following macro-economic factors as significant and mostly used in explaining security returns: surprises in inflation surprises in GNP as indicated by an industrial production index surprises in investor confidence due to changes in default premium in corporate bonds Surprise shifts in the yield curve.

Methodology

Most studies used in this paper were merely exploratory instead of experimental, so no scientific methodology was used in most of them However, one interesting study conducted by kumar, has used S&P CNX Nifty index as a proxy for the stock market and the closing values were collected from Jan 1,2001 till December 31, 2006. 60 samples were used for estimation of the model parameters the remaining observations were used for out of sample forecasting hold out sample. The monthly average prices were converted into continuous compounded returns in the standard method as the log differences: Rt = ln (It / It-1) Where, It stands for the closing index value on day t. [Kumar]

References

A Comparison of CAPM & Arbitrage Pricing Theory by Rakesh Kumar, institute of management, 2005-2007 The Arbitrage Pricing Theory and Multifactor Models of Asset Returns. Gregory Connor London School of Economics and Political Science and Robert A. Korajczyk Northwestern University. September 1992 A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory, Richard Roll and Stephen A. Ross The arbitrage pricing theory, macroeconomic and financial factors, and expectations generating processes, Richard Priestley, Centre for Empirical Research in Finance, Department of Economics and Finance, Brunel Unicersio, March 1995 Do Arbitrage Pricing Models Explain the Predictability of Stock Returns? Wayne E. Ferson, University of Washington, Robert A. Korajczyk, Northwestern University A new approach to international arbitrahe pricing. Ravi Bansal; David A. Hsieh, S. Viswanathan, The Jornal of Finance, Vol. 48, No. 5 (Dec 1993) Arbitrage Pricing Theory, Gur Huberman and Zhenyu Wang Arbitrage Pricing Theory with Estimation Risk, Puneet Handa and Scott C. Linn, Jordan of Financial and Quantitative analysis, Vol 28, No. 1, March 1993 The Arbitrage Pricing Theory, Is It Testable? Jay Shanken, The journal of finance, Vol. XXXVII 1982 No. 5