Describe

the

Arbitrage

Pricing

Theory (APT) model.

Critically
whether

evaluate
the

APT

model is superior to
the

Capital

Pricing
(CAPM)

FIN 400

Tebogo T Kubanji

Asset
Model

Describe the Arbitrage Pricing Theory (APT) model. Critically evaluate whether the APT model is superior
to the Capital Asset Pricing Model (CAPM)

Introduction
The Arbitrage Pricing Theory (henceforth APT) is a theory developed by Stephen Ross (1976) 1
and was later extended by Huberman (1981)2; it is viewed by many as an extension or more
testable alternative to the Capital Asset Pricing Model by William Sharpe (1964)3. Arbitrage
Pricing Theory is based on the law of one price; that is according to arbitrage if there are two
assets which have same risk, theoretically their expected returns should be same. If their
expected returns are different, the arbitrageurs would sell the asset with a lower return and buy
the asset having higher return and thus make some profit which will be the risk free arbitrage
profit.
The Capital Asset Pricing Theory (CAPM) uses the concepts of portfolio valuation and market
equilibrium developed by Markowitz (1960) in order to determine the market price for risk and
appropriate measure of risk for a single asset.
CAPM concerns two types of risk namely unsystematic and systematic risks. The central
principle of the CAPM is that, systematic risk, as measured by beta, is the only factor affecting
the level of return while Arbitrage Pricing Theory is based upon the assumption that there are a
few major macro economic factors that influence security returns i.e. factors such as inflation
growth, GDP growth, interest rate, currency rates industrial production index etc.
In other words, the expected return from a security is a linear function of various factors
affecting the return from the security in the market and each of these factors is represented by a
factor specific beta coefficient.
APT also holds that the correct price of an asset can be determined using the APT model derived
expected rate.

The Arbitrage Theory Of Capital Asset Pricing, journal of economic theory , Dec 1976 343-362
A Simple Approach To Arbitrage Pricing Theory Journal Of Economic Theory, 1982 183-191
3
A simplified Model For Portfolio Analysis, Management Science, Jan 1963, 277-293
2

Describe the Arbitrage Pricing Theory (APT) model. Critically evaluate whether the APT model is superior
to the Capital Asset Pricing Model (CAPM)

Development of the APT

The APT model by Ross was meant to cover the short falls or act as an alternative to the CAPM.
The core idea of the APT is that only a small number of systematic affect the long term average
returns of securities. The first ingredient of Rosss APT is a factor model.
Multi-factor models allow an asset to have not just one, but many measures of systematic risk.
Each measure captures the sensitivity of the asset to the corresponding pervasive factor. If the
factor model holds exactly and assets do not have specific risk, then the law of one price implies
that the expected return of any asset is just a linear function of the other assets expected return.
If this were not the case, arbitrageurs would be able to create a long-short trading strategy that
would have no initial cost, but would give positive profits for sure.
Assumptions of APT

Capital markets are perfectly competitive

Investors always prefer more wealth to less wealth with certainty

The stochastic process generating asset returns can be expressed as a linear function of a
set of K factors or indexes

Assumptions of CAPM not used

APT does not assume

A market portfolio that contains all risky assets, and is mean-variance efficient

Normally distributed security returns

Quadratic utility function

Describe the Arbitrage Pricing Theory (APT) model. Critically evaluate whether the APT model is superior
to the Capital Asset Pricing Model (CAPM)

The APT is therefore given by

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

Where;
0= Risk free rate of return.
NB: In APT risk free rate of return refers to the expected rate of return if the macro-factors remain unchanged and not the risk free rate of return
as normally given by the treasury bills in the CAPM.

1, 2...k= Represent change in macro-factors

bi1, i2...k= Referred to as Betas or sensitivity factors

Empirical Evidence
The acceptability of the Arbitrage Pricing Theory just like that of CAPM or any other theory lies
on its ability to explain relevant empirical evidence.
Many scholars agree that theoretically APT is a more attractive alternative that CAPM as APT is
it is said to requires less stringent and more realistic assumptions, is readily more testable since
does not require market portfolio as a proxy and thus it able to explain anomalies found I the use
of the CAPM to asset returns.
In an empirical investigation of the Arbitrage Pricing Theory in the Japanese equity market using
Japanese macroeconomic factors. Yasushi Hamao (1988) 4 examined macro-economic factors
such as industrial production, inflation, investor confidence, interest rate, foreign exchange, and
oil prices.

Describe the Arbitrage Pricing Theory (APT) model. Critically evaluate whether the APT model is superior
to the Capital Asset Pricing Model (CAPM)

He examined the international robustness of the theory and compared the results with those for
the U.S. Evidence of the risk premia on the multiple factors presented. He noted that the is a
relationship between macro-economic factors and stock prices.
He also tested the validity of the CAPM. The result shows that the CAPM beta does not capture
any extra risk that may have been missed by the macroeconomic factors

Closer to home, Petros Jecheche (2005)5 did an empirical investigation of APT in Zimbabwe. In
his study he used the vector autoregressive (VAR) framework, the Granger causality.
The Granger causality tests were conducted to establish the existence of causality among the
variables like inflation, exchange rate and Gross Domestic Product. Although the Granger
causality tests showed no significant relationship between stock prices and exchange rate or real
GDP the vector autoregressive showed that the real GDP explains deviations in the Stock Prices.

Other empirical tests of APT have shown that assets returns are explained by three possibly more
factors and have ruled out the asset`s own variance as a factor.

Shortfalls
Although APT is great at explaining the pricing of assets it does have a few shortfalls in that it
requires investor to perceive the risk sources and that they can reasonably estimate these factors
sensitivities. Even professors and other academics cannot seem to agree on the risk factors, and
the betas one can estimate, the more statistical noise you have to deal with. 6

APT assumes that investors will hold well-diversified portfolios where else it has been shown by
Blume and Friend (1978) that large proportion of individual`s stock portfolios and other asset`s
holdings are highly undiversified.

Conclusion
5

Research in Business and Economics Journal, An Empirical Investigation of Arbitrage Pricing Theory: A case
Zimbabwe
6

Financial theory and Corporate Finance, Copeman, Weston & Shastri

Describe the Arbitrage Pricing Theory (APT) model. Critically evaluate whether the APT model is superior
to the Capital Asset Pricing Model (CAPM)

Even with APT having its own weakness it is still a much better asset pricing model than CAPM
because of the following reasons7;

It allows the selection of whatever factors that provides a better explanation of variations
in stock market prices.

The APT yields a statement about the relative pricing of any subset of assets; hence one
need not measure the entire universe of assets in order to test the theory

The APT is derived from a statistical model whereas the CAPM is an equilibrium asset
pricing model. In APT we do not have to assume that every investor is trying looking to
an optimal portfolio but this was the assumption in CAPM and thus this makes APT a
more reasonable theory.

APT can also be applied to cost of capital and capital budgeting.

There is no special role for the market portfolio in the APT, whereas the CAPM requires
that the market portfolio be efficient.

The APT makes no assumptions about the empirical distribution of asset returns. CAPM
assumes normal distribution.

It is more readily testable as it does not require the measurement of the portfolio beta.

Number of Word; 1418

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Describe the Arbitrage Pricing Theory (APT) model. Critically evaluate whether the APT model is superior
to the Capital Asset Pricing Model (CAPM)

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