Nottingham University Business School MBA Programmes

PORTFOLIO MANAGEMENT & INVESTMENT ANALYSIS
N14M29 How useful is Arbitrage Pricing Theory?

Module Convenor: Professor Bob Berry

Dmitry Solomatin Student ID: 4177973

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Word count: 2980

Table of Contents

I II III IV V

Introduction…………………………………………………………… 3 Theoretical background..…………………………………………... 3 Practical applications of APT……………………………………... 5 Current issues with APT.......………….………………………..…. 7 Conclusion .………………………………………………………….. 8

References

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I Introduction
In order to identify the forces that influence stock prices, a vast number of researches have been conducted by practitioners and academics. A financial theory gives a range of asset pricing models which are relevant to a relation between expected returns and one or a variety of variables that illustrate various sources of risk. Identifying these variables is based on the assumptions on which the model is established. Predominantly, there are two widely used models: the Capital Asset Pricing Model (CAPM) with one source of risk and the Arbitrage Pricing Theory (APT) that takes into account several factors of risk. Both models might be used in assessment of the performance of securities or measurement of cost of capital. This essay is aimed to explore practical applications of the APT model in the stock markets. The paper is organized into five sections including the introduction and conclusion sections. Section 2 provides a theoretical background on the fundamental models of APT. Section 3 outlines an importance of the model from the practical point of view. Section 4 shows the downside of using the APT alongside its limitations.

II Theoretical background
The Arbitrage Pricing Theory was developed by Stephen Ross in 1976. The theory explains the implications of various risk-factors in value of securities. Those implications involve changes in asset prices depending on the contribution of each risk-factor to the value of the asset. Those reflections might happen straight away or over time influenced by a combination of specific unrelated macro-economic variables. APT has been developed as the further improvement of CAPM model published by Sharpe in 1964. CAPM model has more rigid and less realistic assumptions, yet it does not take various risk-factors into account. That is the reason why APT has been also popular since its origination. Elton et al (2011) gave us the formula to calculate expected returns on the asset:

R ᵢ = ɑᵢ + bᵢı Iı + bᵢ2 I2 +… + bᵢ ȷ I ȷ + eᵢ
where

ɑᵢ = the expected level of return on stock ᵢ if all indices have a value of zero, I ȷ = the value of the ȷth index that impacts the return on stock ᵢ , bᵢ ȷ = the sensitivity of stock ᵢ’s return to the ȷth index, eᵢ = a random error term with mean equal to zero and variance equal to Ϭₑᵢ²

Thus, the main message from this model is that two analogous assets must be sold at the same price. In other words, there are no arbitrage opportunities. Consequently, if two similar assets are

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sold at different prices, there is an arbitrage opportunity – a riskless profit might be taken by buying the asset which is cheaper in one market, and selling it in the more expensive market. According to Defusco et al (2007) APT model based on following assumptions: 1) 2) 3) 4) 5) Relationship between expected returns and risk-factors is linear. A quantity of securities is close to infinite. Expectations of investors are identical. Stock markets are perfect (there are no transactions costs and competition is perfect). There are no arbitrage opportunities in the market among well-diversified portfolios.

The Arbitrage Pricing Theory considers only macroeconomic risk-factors, such as interest rates, unanticipated inflation or unemployment rates which affect every company in the stock market and might be determined as systematic risk, consequently can be estimated by this model. In turn, microeconomic factors that affect companies performance, such as key executives’ resignations, the failure to launch a new product or the prosecution caused by the unsatisfied customer, might be considered as firm-specific factors, therefore can be reduced by diversification. Difference between the APT model and CAPM in that APT is more flexible in its assumptions. It gives investors more freedom to build up a model which could explain the expected return for a certain security. Since it is far less restrictive than the CAPM, the expected return on a stock can be represented as a function of several factors and how sensitive the stock to these factors. As long as these factors start moving over time, so does the expected return on the asset. As a result, this must be considered by investors to adjust their decisions according to the market conditions. In comparison to APT, CAPM based on the statement that the expected return might be portrayed by the fluctuation of that asset with respect to the rest of the market. Generally speaking, CAPM can be considered as APT alternative, with only factor should be taken into account is the risk of the asset relative to the remaining market which is described by the beta of the stock. Chen, Roll and Ross (1986) suggested that the systematic influence affecting expected returns must be also having impact on discount factors and expected cash flows. They concluded that the most significant factors might be industrial production influencing cash flow expectations, the spread between low-risk corporate bond yields and high-risk corporate bond yields which is the risk premium, and the yield curve twists measured by the spread between short-term and longterm interest rates. Less important factors are unanticipated inflation and movements in expected inflation. Berry et al (1988) gave useful guidance which factors might be suitable to use APT. They declared three important attributes that risk-factors must hold: 1) At the starting point of the time interval, the factor must not be predictable to the market. This means that at the beginning of the period this factor is impossible to forecast from its past performance or from public information available to the stock market. 2) Every factor must have prevalent impact on the stock returns. This means that firmspecific events cannot be taken into account as they are considered as firm-specific riskfactors that might be mitigated by diversification. 3) Appropriate factors cannot have zero prices in order to influence expected returns. In other words, if the factor equal zero, it has no impact on returns.

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III Practical applications of APT
The APT model has been tested in Cauchie, Hoesli and Isakov (2002) paper. They came up with conclusions that local markets, such as Swiss stock market, are influenced by local and global factors, regardless the fact that more than 80% Swiss companies represented in the stock market operate globally, therefore should be entirely integrated internationally. In fact, the results indicate only the partial integration. Four factors have been identified: business cycle, inflation, interest rates and financial markets performance. These factors are related to cash flows and discount rates and therefore to the share prices. Thus, practical implications in that elements should be taken into consideration in terms of hedging motives, performance measurement and calculations of cost of capital. APT is widely used in estimating of shares by investors. Institutional investors as well as companies that provide their customers with brokerage employ this theory to calculate the fair price of assets at any given time. If the current price is lower than their expectations, they recommend to buy. Likely, if the actual price is higher than their predictions, they advise to sell. APT is also helpful for fund managers to eliminate from all fears since they have knowledge on real valuation of stocks and the risks involved in price determination. Moreover, APT is useful to determine the sources of systematic risk, therefore it can divide systematic risk into separate components. As a result, a fund manager has the tool to modify its portfolio of shares with respect to different risk-factors. For instance, if the manager has oil companies in the portfolio and there is an expectation of a decrease in oil prices, the manager can take an aggressive position to mitigate that risk, e.g. acquiring assets that are insensitive to oil prices, such as paper, packaging or transport industries. (Faff and Brailsford, 1999). APT is also widely used to identify sensitivity stock markets to a certain risk-factor, such as oil prices, as mentioned above. Ferson and Harvey (1995) examined eighteen countries and concluded that not all countries are sensitive to oil prices at the same level. Some stock markets are very sensitive, but some markets are invariant to oil prices. Jones and Kaul (1996) found out that oil is certainly risk-factor and might be priced. Yet, there are three levels of the stock market dependence: global level, country level and industry level. Thus, APT helps to identify how oil prices affect a particular level of stock markets. Therefore analysts can calculate strength of the oil factor related to the market they are interested in. The APT model might be useful to investors in terms of knowledge of the factors which affect the ability of APT to evaluate the cost of capital more precise, therefore it can reduce the level of uncertainty and stimulate investments in the long run. Moreover, analysis of these factors will not only provide the investor with understanding of the nature of the economic situation, but also give individual the opportunity to assess the economy and formulate his or her future course. As far as managers are concerned, APT allows them to follow forecasts prepared by economists and professionals to assess unexpected changes in the economic indicators that have impact on expected returns. Fund managers are interested in fund performance analysis which, in turn, influenced by macroeconomic factors. Therefore it will help them to make right decisions and predict the future course taking into consideration cash flows, growth, profits and share price. Huberman and Wang (2005) suggested three areas of applications of the APT model: asset allocation, the calculation of the cost of capital and the assessment of performance of managed funds.

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APT is relevant to asset allocation since the link between the factor structure and mean-variance efficiency does exist. APT is helpful to construct an optimal portfolio since this model imposes its restrictions in the evaluation of the mean and covariance matrix which involved in the meanvariance analysis. This constraint allows to increase validity of the evaluation as it decreases the amount of unknown variables. According to Elton et al (2011), APT is widely used in passive portfolio management, particularly in index funds that are tracking a certain index, such as S&P500, or in a passive portfolio with certain attributes according to client’s requirements. In order to track the index, a portfolio manager should buy all shares included in the index. In case of S&P500, the number of shares equal 500. Since S&P500 is not constant over time, the fund manager needs to adjust the portfolio following each change in S&P500 composite. This process tends to be difficult and expensive, as a result of limited liquidity of some shares and transactions costs. In that sense the APT model allows to reduce a number of shares to represent the index. The index portfolio might be constructed from a sufficient number of shares that reflect return movements (risk). Construction of the portfolio with specific requirements is also subject to apply the APT model. Looking at pension funds, it is the most critical aspect to protect the portfolio of assets from inflation. Since APT might define a sensitivity factor to inflation, the portfolio can be constructed taking into account this factor, therefore this allows to protect the portfolio from negative impact of inflation. Investors involved in active portfolio management may enjoy an ability of the APT model to increase portfolio performance. If the investor believes that his or her forecast related to GDP growth, as example, for next year better than expected by market, the investor can change the risk-factor coefficient in the APT equation, then the expected return on this share will be higher and the investor will be awarded higher return from his or her ability to predict factors better than the stock market. APT is also used to compute the cost of capital. A number of studies apply the model to study cost of capital for various industries when one or several macroeconomic factors have impact on expected returns of firms in the particular sector. For instance, Antoniou, Garrett and Priestley (1998) examined impact of the European exchange rate mechanism on the cost of capital for several industries using APT. Performance of fund managers makes individual investors as well as institutional ones interested in measurement of their performance. APT in this case is used by regressing fund’s returns on the factors, and then the intercepts are compared with benchmark securities’ returns such as Treasury bills. Similar way to evaluate fund managers performance is used in the following example. Let us assume that the fund has outperformed S&P500 index. To analyze that, we can break up the fund’s returns into the following elements:  Expected return from S&P500 index (used as the benchmark)  Extra return on S&P500 index that is earned from factors having returns that are different from their expected value  Extra expected return earned from having sensitivities different from those on S&P500 index  Extra return earned from having sensitivities different from those of S&P500 index that is earned because factors have returns that are different from their expected values  Extra return from security selection 6

(Elton et al , 2011: 659) Considering every component of the fund’s return, we can evaluate manager’s contribution to this return, therefore manager’s skills.

IV Current issues with APT
APT has been actively criticized in many ways, particularly, that this theory does not tell investors which factors are for a certain asset. In the real world one security might be more sensitive to one determinant than another. For instance, the stock price of BP tends to be more sensitive to oil prices than to interest rates. On the other hand, the price of a share of Bank of America is likely to be more sensitive to interest rates rather than to oil prices. Thus, APT leaves the choice of risk factors to the investor and he or she must identify three variables. Firstly, which factors affect a certain asset. Secondly, what the expected returns are for each of these factors. Finally, what the sensitivity is for each of these elements of risk. In practice, identification of those factors and their further quantification are not easy way to value a certain asset for analysts. For this reason CAPM dominates the theory to examine the relation between the return and risk on the asset. Looking at the formula of APT, it is fairly clear that there are a large number of factors that need to be potentially taken into account, therefore more betas are calculated to get an expected return on an asset. The more calculations, the more complexity is added to get a real result. This argument might be considered as downside of using APT model. Cagnetti (2007) examined Italian stock market using CAPM and the APT model. Empirical tests of this study revealed a weak relationship between beta and expected returns by CAPM, therefore to this market this model has poor explanatory power. On the other hand, APT performed better, but still explained only 44% of the overall variation. There could be a number of possible explanations for this. Firstly, by assumption, the APT model is static, in other words, risk and expected returns are not changing over a period of time. In reality, risk and expected returns influenced by market forces during that period, as a result are not stationary. Secondly, APT might be relevant to not all months of the year, and “January effect” could be reason for failure of APT (Gultekin and Gultekin, 1987). Thirdly, according to the strong assumption, there is the linear relationship between APT and risk-factors, therefore that relationship is simplified by the linear model, although, in reality, the relationship might be more complex. Groenewold and Fraser (1997) pointed out that APT has not only strengths, such as a number of risk-factors are available to researchers to model the relationship between expected returns and the factors which are accessible at the moment, but also weaknesses, such as the impossibility to identify these factors easily, compared to CAPM used equity’s beta. In spite of Dhrymes, Friend and Gultekin (1984) admitted that APT has better explanatory power, compared to the one-factor model, they also pointed out that this power is not strong enough, yet, they had some doubt whether the risk-factors provided by Roll and Ross (1980) are considerably different from zero.

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Overall, the literature has provided us with plenty of studies of empirical evidence of APT’s importance, however, many studies have still shown ambiguous results, consequently, the APT model gives us contradictory conclusions based on flexible assumptions and complexity of its nature. It has become clear that analysts and practitioners need to have further guidance how to specify risk-factors and their weights in order to systematize computations of expected returns on assets.

V Conclusion
The aim of this study was to explore practical applications of the APT model in the stock markets. The theoretical background has been examined by identifying the latest academic findings in asset pricing theories. The result clearly shows that the APT model seems to be a superior asset pricing model compared to CAPM. However, one of the main weaknesses of APT is that it does not give any guidance, which factors might be used and what is correct amount of them. In addition, from the several studies, it can be concluded that APT has better explanatory power, compared to CAPM, when its aim is the identification of the links between the expected returns and the risk-factors. More realistic assumptions of APT clearly play an important role to give better results and empirical evidence in researches. This paper has also explored important implications for both researchers and practitioners. From a research point of view, this study stresses APT’s importance as an alternative to CAPM with its strengths and weaknesses. From a practical point of view too, it has several implications. First, it shows that APT is helpful tool in portfolio management to construct the portfolio according to client’s requirements who has an opportunity to specify the portfolio sensitivity to different macroeconomic factors. Second, APT might be supportive in calculations of the cost of capital for forecasting purposes. Finally, APT is an effective instrument to measure fund managers performance.

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References
Antoniou, A., Garrett, I. and Priestley, R. (1998) Calculating the equity cost of capital using the APT: the impact of the ERM, Journal of International Money and Finance, 14, pp. 949-965. Berry, M.A., Burmeister, E. and McElroy, M. (1988) Sorting out risks using known APT factors, Financial Analyst Journal, 44(2), pp. 29-41. Cagnetti, A. (2007) Capital Asset Pricing Model and Arbitrage Pricing Theory in the Italian stock market: an Empirical Study. Management School of Economics. The University of Edinburgh. Downloaded from http://hdl.handle.net/1842/1821 as at 25th March 2011. Cauchie, S., Hoesli, M. and Isakov, D. (2002) The determinants of stock returns in a small open economy, National centre of competence in Research financial valuation and risk management, 80, pp. 1-30. Chen, N.F., Roll, R., Ross, S.A. (1986) Economic forces and the stock market, Journal of Business, 59(3), pp. 383-404. Defusco, R.A., McLeavey, D.W., Pinto, J.E. and Runkle, D.E. (2007) Quantitative Investment Analysis, 2nd ed., Canada: John Wiley & Sons. Dhrymes, P.J., Friend, I. and Gultekin, N.B. (1984) A critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory, The Journal of Finance, 39(2), pp. 323-346. Elton, E.J., Gruber, M.J., Brown, S.J. and Goetzmann, W.N. (2011) Modern portfolio theory and investment analysis, Hoboken, NJ: John Wiley & Sons. Faff, R.W. and Brailsford, T.J. (1999) Oil price risk and the Australian stock market, Journal of Energy Finance and Development, 4, pp. 69-87. Ferson, W. and Harvey, C.R. (1995) Predictability and time-varying risk in world equity markets, Research and Finance, 13, pp. 25-88. Groenwold, N. and Fraser, P. (1997) Share prices and macroeconomic factors, Journal of Business Finance and Accounting, 24(9), pp. 1367-1381. Gultekin, M.N. and Gultekin, N.B. (1987) Stock Returns Anomalies and the Tests of the APT, Journal of Finance, 42(5), pp. 1213-1224. Huberman, G. and Wang, Z. (2005) “Arbitrage pricing theory” in The New Palgrave Dictionary of Economics, 2nd ed., edited by L.Blume and S.Durlauf, London: Palgrave Macmillan. Jones, C. and Kaul, G. (1996) Oil and the stock market, Journal of Finance, 51, pp. 463-491. Roll, R. and Ross, S.A. (1980) An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, 35(5), pp. 1073-1103. Ross, S. (1976) The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, 13, pp. 341-360.

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Sharpe, W. (1964) Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, 19, pp. 425-442.

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