The Arbitrage Pricing Theory

Introduction
The capital asset pricing model that assists the security have different expected return because they have different beta however they exists an alternative model of asset pricing that was developed by Stephen Ross it is known as arbitrage pricing model. Arbitrage pricing theory (APT) is an equilibrium model of security prices, as is the capital asset pricing model (CAPM). It makes different assumptions than the CAPM does. APT assumes that security returns are generated by a factor model but does not identify the factors. An arbitrage portfolio includes long and short positions in securities. it must have a net market value of zero, no sensitivity to any factor, and a positive excepted return. Investors will invest in arbitrage portfolios, provided they exist, driving up the prices of the securities held in long positions until all arbitrage possibilities have been eliminated. When all arbitrage possibilities have been eliminated, the equilibrium expected returns on a security will be a linear function of its sensitivities to the factors a factor-risk premiums is the equilibrium to the factors and no sensitivity to any other factor APT does not specify the number or identify of the factors that affect excepted returns or the magnitudes or signs of the risk premiums. Most research into factors has focused on indicators of aggregate economic activity, inflation and interest rates

Limitations of CAPM formed the Arbitrage pricing theory
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It is based on Unrealistic Assumptions  Difficult to find risk free assets  Equality of lending and borrowing rates

2. 3.

It is difficult to test the validity of CAPM BETAS do not remain stable over time.

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2.Assumptions of the Arbitrage pricing theory 1. The investors are risk averse and utility maximize. Perfect competition prevails in the market an there is no transaction cost. 4. 3. Under APT investors borrows and lend at risk free rate. 5. The investors have homogenous expectations. 6. 3 . Investors agree on the number and identify of the factors that are important symbolically in pricing asset. There is no market friction such as transaction cost or restriction on short selling.

where beta is exposed to changes in value of the market. It allows for an explanatory (as opposed to statistical) model of asset returns. as opposed to the identical "market portfolio". 4 . On the other side. Additionally. the APT can be seen as a "supply-side" model. the CAPM can be considered a "special case" of the APT in that the securities market line represents a single-factor model of the asset price.Relationship with the capital asset pricing model The APT along with the capital asset pricing model (CAPM) is one of two influential theories on asset pricing. arise from a maximization problem of each investor's utility function. since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. although similar to those of the APT. factor shocks would cause structural changes in assets' expected returns. Thus. or in the case of stocks. in firms' profitability. the capital asset pricing model is considered a "demand side" model. and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets). Its results. It assumes that each investor will hold a unique portfolio with its own particular array of betas. In some ways. The APT differs from the CAPM in that it is less restrictive in its assumptions.

Principle Arbitrage is the process of earning profit by taking advantage of differential pricing for the some physical asset or security. Because arbitrage profits are by definition riskless all investors are motivated to tale advantage of then whenever they are discovered. eliminates these profit opportunities. As widely applied investment tactic. efficient security markets. It only takes few of these active investors to exploit arbitrage situations and by their buying and selling actions. arbitrage typically entails the sale of security at a relatively high price and the simultaneous purchase of the same security at a relatively low price. 5 . It only takes a few of these active investors to exploit arbitrage than others. The nature of arbitrage is clear when discussing different prices for an individual security. However “almost arbitrage” opportunity involve similar securities or portfolios. The similarity can be defined in many ways for example in the exposure to pervasive factor that affect security prices. Arbitrage is critical element of modern. Granted some investors are greater resources and are more inclined to engage in arbitrage than others.

i. Under the APT.a portfolio consisting of other correctly priced assets. that arbitrage by investors will bring asset prices back into line with the returns expected by the model. an asset is mispriced if its current price diverges from the price predicted by the model. whereas under APT arbitrage as described below. This portfolio has the same exposure to each 6 . The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap. the investor locks-in a guaranteed payoff. the investor locks-in a positive expected payoff. arbitrage consists of trading in two assets – with at least one being mispriced.e. A correctly priced asset here may be in fact a synthetic asset .Arbitrage and the APT Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets and thereby making a risk-free profit. Arbitrage mechanics In the APT context. The APT thus assumes "arbitrage in expectations" . Arbitrage in expectations The APT describes the mechanism of arbitrage whereby investors will bring an asset which is mispriced. according to the APT model. where the expected return of the asset is a linear function of various factors. sees rational pricing. Note that under true arbitrage. and sensitivity to changes in each factor is represented by a factor-specific beta coefficient. back into line with its expected price. The asset price today should equal the sum of all future cash flows discounted at the APT rate.

The arbitrageur is thus in a position to make a risk-free profit: Where today's price is too low: The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT. The arbitrageur could therefore: Today: 1 short sells the portfolio 2 buy the mispriced asset with the proceeds. 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 net-zero exposure to any macroeconomic factor and is therefore risk free (other than for firm specific risk). 7 .of the macroeconomic factors as the mispriced asset. whereas the mispriced asset would have appreciated at more than this rate. At the end of the period: 1 sells the mispriced asset 2 use the proceeds to buy back the portfolio 3 pocket the difference. 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.

(3. Within the context of The APT. As a concrete example. Stocks that have small values for this parameter will react only slightly as F changes. which is assumed to be uncorrelated across different stocks. the variations in which cause variations in individual stock returns.1. the returns on stock i are related to two main components: 1. variations in F cause very large movements in the return on stocki. This factor is posited to affect all stock returns. The sensitivity of stock i’s return to F is βi.the S&P-500 or the FTSE-100). both will tend to move in the same direction.Factor model Single-factor models Before using the notion of absence of arbitrage to provide pricing relations. The simplest factor model. given below. although with differing sensitivities. The first of these is a component that involves the factor F. 2. this basis is given by the assumption that the population of stockreturns are generated by a factor model. this term causes movements in individual stock returns that are related. We have denoted this term εi and call it the idiosyncratic return component for stock i. is a one-factor model: ri = αi + βi F + εi E(εi) = 0. Hence. If two stocks have positive sensitivities to the factor. think of F as the return on a market index (e. whereas when βi is large. An important property of the idiosyncratic component is that it is also assumed to be uncorrelated with F. The second term in the factor model is a random shock to returns. We need a basis for the generation of stock returns.g.1) In equation 3. the common factor in 8 .

Further. which determine how sensitive the return on the stock in question is to variations in each of the factors.. F) = 0 i An example of such an idiosyncratic stock return might be the unexpected departure of a firm’s CEO or an unexpected legal action brought against the company in question. In statistical terms we can write the conditions on the idiosyncratic component as follows: Cov(εi. --------------------------------------- Multi-factor models A generalisation of the structure presented in equation 3. 9 .1 implies that all common variation in stock returns is generated by movements in F (i.. The partition of returns implied by equation 3. ri = αi + β1iF1 + β2iF2 + . (3. + βkiFk + εi E(εi) = 0.e.e. Note that this assumption implies that the expected return on asset i is just given by the constant in equation 3. the correlation between the returns on stocks i and j derives solely from F). Each stock has a complement of factor sensitivities or factor betas.2 (i.2) Again the idiosyncratic component is assumed uncorrelated across stocks and with all of the factors.stock returns. financial conditions or political events.1 posits k factors or sources of common variation in stock returns. we’ll assume that each of the factors has a mean of zero. These factors can be thought of as representing news on economic conditions. E(ri) = αi). εj) = 0 i ≠ j Cov(εi. Asthe idiosyncratic components are ncorrelated across assets they do not bring about covariation in stock price movements..

04 + 0.04 β1p = 1 3 (1 + 0.25 F1 – 0. Subscripting the coefficients for the equally weighted portfolio with a p we have: αp = 1 3 (0. The following example will demonstrate the point.03 + 0.e.25) = 0.1F2 + εp where the final term is the idiosyncratic component in the portfolio return.5 β2p = 1 3 (–0. Y. all we need to do is form a weighted average of the stock sensitivities on the individual assets.A pertinent question to ask at this point is how do we determine the return on a portfolio of assets given the k-factor structure assumed? The answer is surprisingly simple: the factor sensitivities for a portfolio of assets are calculable as the portfolio weighted averages of the individual factor sensitivities.3) = –0. and Z are determined by the following two-factor model: rX = 0.1. we wish to derive the factor structure followed by an equally weighted portfolio of the three assets (i.04) = 0. Example The returns on stocks X.04 + 0.5F2 + εY rz = 0. a portfolio with one-third of the weights on each of the assets). Following the result mentioned above. and hence.03 + 0.75 F1 + 0.5 + 0.5F2 + εX rY = 0. 10 .3F2 + εz Given the factor sensitivities in the prior three equations.5F1 – 0.05 + F1 – 0. the factor representation for the portfolio return can be written as: rp = 0.05 + 0.5 –0.75 – 0.

this requirement of a three security arbitrage portfolio is one factor can be written as B1X1 +b2X2+ b3X3 =0 3. this requirement of a three security arbitrage portfolio written as X1+ X2+X3 =0 2.1. If Xi denotes change in the investors holding of security I. It does not require any additional funds from the investor. It has a positive expected return. an investor will explore the possibility of forming an arbitrage portfolio in order to increase the expected return of his or her current portfolio without increasing its risk. It has no sensitivity to any factor because the sensitive of a portfolio factor is just a weighted average of the sensitivities of the securities in it ie to that factor. Mathematically this third and last thing for a three security arbitrage portfolio is X1r1+X3r2+X3r3 >0 11 . Just what is an arbitrage portfolio? There are three characteristic of an arbitrage portfolio .Arbitrage portfolio According to APT.

we have to construct the factors empirically: (a) Using macroeconomic variables: • changes in GDP growth • changes in T-bill yield (proxy for expected inflation) • changes in yield spread between T-bonds and T-bills • changes in default premium on corporate bonds • changes in oil prices (proxy for price level) 12 . Since the theory itself does not specify the factors. Estimate factor loadings of assets 3. Factors. Estimate factor premia. 1.Implementation of APT The implementation of APT involves three steps: 1. Identify the factors 2.

Growth rate in industrial production 2. Given the factors. 15.. several researchers have investigated stock returns and have estimated that anywhere from three to five factors are “priced” various people attempted to identify those factors nai –fu chen. Factor Premia. Richard roll. Identifying the factors Left unanswered by APT are the number and identify of the factors that have value of lambda (λ) that are sufficiently positive or negative in magnitude that they need to be included when estimating excepted returns.(b) Using statistical analysis – factor analysis: • estimate covariance of asset returns • extract “factors” from the covariance matrix (c) Data mining: Explore different portfolios to find those whose returns can be used as factors. we can construct factor portfolios. and Ross and the other two 13 . Given the factor loading of individual assets. we can regress past asset returns on the factors to estimate factor loadings (bik): ˜rit = ¯ri +bi1 ˜ f1t +· · ·+biK ˜ fKt +uit. Spread between low-grade and high grade bonds Michael berry. Factor Loadings. Edwin Burmeister and Marjorie McElroy identify five factor .three correspond closely to the last three identified by Chen. Rate o f inflation (both expected and unexpected) 3. 3. and Stephen Ross identify the following factors 1.407 Lecture Notes Fall 2003 c_Jiang Wang Chapter 12 Arbitrage Pricing Theory (APT) 12-15 2. Roll. Spread between long term and short –term interest rates 4.

2. first contain some indication of aggregate economic activity (industrial production. Growth rate in gross national product. is the same as the factors identified by the others. aggregator sales and GDP) second. Rate of growth in defense spending It is interesting to note that the three sets of factors have common characteristics. the APT. the factors make intuitive sense.their impact on asset prices manifests in their unexpected movements 2.the number and nature of these factors is likely to change over time and between economies. The remaining factors are as follows: 1.timely and accurate information on these variables is required 14 . inflation.they should represent undiversifiable influences (these are. Third. Several a priori guidelines as to the characteristics required of potential factors are. Rate of interest 3. clearly. Further dividends are related to aggregate economic activity and the discount rate used to determine present value is related to inflation and interest rates Using the APT As with the CAPM. the factor-specific Betas are found via a linear regression of historical security returns on the factor in question. As a result. suggested: 1. Only one factor. more likely to be macroeconomic rather than firm-specific in nature) 3. . however. Unlike the CAPM. they contain some type of interest rate factor (either spreads or a rate itself) because stock prices are equal to the discounted value of future dividends.are the growth rate in aggregate sales in the economy and the rate of return on the S &P 500 Finally.consider the five factors used by Salomon Brothers (now Salomon Barney) in their fundamental factor model. Rate of change in oil prices 4. however. this issue is essentially empirical in nature. does not itself reveal the identity of its priced factors . they include inflation.

Under APT risk return analysis is not the basis while in the case of CAPM risk return analysis is necessary. since its beta coefficients reflect the sensitivity of the underlying asset to economic factors On the other side. 3.a diversified stock index such as the S&P 500 or NYSE Composite Index. 2. the difference in long-term and short-term interest rates. where beta is exposed to changes in value of the market. More direct "indices" that might be used are: short term interest rates. 4.g. the capital asset pricing model is considered a "demand side" model. Roll and Ross (1986) identified the following macro-economic factors as significant in explaining security returns: surprises in inflation. which are reported at low frequency (e. and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets). The APT can be seen as a "supply-side" model. 15 . Under APT investors do not look at expected returns and standard deviation while in the case of CAPM investors look at the expected return and accompanying risk measured by standard deviation. surprises in GNP as indicted by an industrial production index. indices or spot or futures market prices may be used in place of macroeconomic factors. monthly) and often with significant estimation errors.the relationship should be theoretically justifiable on economic grounds Chen. Market indices are sometimes derived by means of factor analysis. arise from a maximization problem of each investor's utility function. Differences between APT and CAPM’s 1. although similar to those of the APT. The CAPM can be considered a "special case" of the APT in that the securities market line represents a single-factor model of the asset price. As a practical matter. surprises in investor confidence due to changes in default premium in corporate bonds surprise shifts in the yield curve.oil pricesgold or other precious metal prices Currency exchange rates.4. Its results.

the technique of factor analysis (a statistical technique) is applied to stock returns to discover the basic factors. 2. Empirical evidence The APT has been empirically tested two different approaches. in the first approach. APT is based on the return generated by factor models.5. while in the case of CAPM investors maximize wealth for a given level of risk. The number of basic factors. Empirical studies done so far suggest that there is hardly any consistency in terms of: 1. 16 . These are then examined to see whether they correspond to some economic or behavioral variables. The interpretation that may be put on these factors (typically the factors identified are artificial constructs representing several economic variables).

They employ four factors: 1. 4. typifies this approach. Strength and Weaknesses of APT 1. 6. Default risk premiums. rather than extracted by analyzing stock returns. 5.3. 17 . In the second approach. Model itself does not say what the right factors are. The classical work of Roll and Ross. factors are specified a priori. 2. The stability of these factors from test to test. Inflation rate. Estimating multi-factor models requires more data. Sensitivity to unanticipated changes in these factors provides explanations for differences in excepted returns among stocks in their study. No need to measure market portfolio correctly. Term structure of interest rates 4. The model gives a reasonable description of return and risk. Industrial production 2. Factors can change over time. 3. Factors seem plausible. 3.

further. 18 . and interest rate risk. Some may reflect macroeconomic factors. that expected stock returns are linear in the return on the market. alternative view of the world from the CAPM. like inflation. Empirical research has indicated that some of the well-known empirical problems with the CAPM are driven by the fact that the APT is really the proper model of expected return generation.Conclusion The APT gives us a straightforward. The CAPM implies that the only factor that is important in generating expected returns is the market return and. whereas others may reflect characteristics specific to a firm’s industry or sector. The APT allows there to be k sources of systematic risk in the economy.

Bailey. William F. 19 . Alexzander Jeffery V.Bibliography Security analysis and portfolio management Punithavathty pandian Fundamentals of investments.Sharpe Gorden J.

Investment analysis and portfolio management. www. Google. Prasana Chandra.com 20 .

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