Arbitrage Pricing Theory

Submitted by - Paras Walia Roll no. 1273595 MBA 3rd (F2)

Arbitrage Pricing Theory (APT)

CAPM is criticized because of the difficulties in selecting a proxy for the market portfolio as a benchmark An alternative pricing theory with fewer assumptions was developed: Arbitrage Pricing Theory

Arbitrage Pricing Theory - APT

Three major assumptions: 1. Capital markets are perfectly competitive 2. Investors always prefer more wealth to less wealth with certainty 3. The stochastic process generating asset returns can be expressed as a linear function of a set of K factors or indexes

Assumptions of CAPM That Were Not Required by APT

APT does not assume A market portfolio that contains all risky assets, and is mean-variance efficient Normally distributed security returns Quadratic utility function

Arbitrage Pricing Theory (APT)

Rt Rf bi1 f i bi 2 f 2 ... bik f k i
Rit is the required rate of return for security i at t time period. Rf is Risk Free Rate of Return f is a factor is a relationship between security price and its factor.

Arbitrage Pricing Theory (APT)

CAPM has only one single non company factor and a single beta In APT, there are basically two factors company and non company based. Each factor has one beta

Arbitrage Pricing Theory (APT)

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

where: 0= the expected return on an asset with zero systematic risk where 0 0 1= the risk premium related to each of the common factors - for example the risk premium related to interest rate risk 1 i 0 bi = the pricing relationship between the risk premium and asset i - that is how responsive asset i is to this common factor K

E E

in the rate of inflation. The risk premium 1= changes related to this factor is 1 percent for every 1 percent
change in the rate

Example of Two Stocks and a Two-Factor Model

(1 .01)

growth in real GNP. The average risk premium 2= percent related to this factor is 2 percent for every 1 percent
change in the rate

(2 .02)

rate of return on a zero-systematic-risk asset (zero 3= the beta: b =0) is 3 percent

oj

(3 .03)

Example of Two Stocks and a Two-Factor Model

bx1= the response of asset X to changes in the rate of inflation

is 0.50

(bx1 .50)

by1= the response of asset Y to changes in the rate of inflation

is 2.00

(by1 .50)

bx 2 = the response of asset X to changes in the growth rate of

real GNP is 1.50

(bx 2 1.50)

b y 2= the response of asset Y to changes in the growth rate of

real GNP is 1.75

(by 2 1.75)

Ei 0 1bi1 2bi 2

Example of Two Stocks and a Two-Factor Model

= .03 + (.01)bi1 + (.02)bi2 Ex = .03 + (.01)(0.50) + (.02)(1.50) = .065 = 6.5% Ey = .03 + (.01)(2.00) + (.02)(1.75) = .085 = 8.5%

Arbitrage Pricing Theory (APT)

The problem with this is that the theory in itself provides no indication of what these factors are, so they need to be empirically determined. The potentially large number of factors means more betas to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM.

Roll-Ross Study
The methodology used in the study is as follows: 1. Estimate the expected returns and the factor coefficients from time-series data on individual asset returns 2. Use these estimates to test the basic crosssectional pricing conclusion implied by the APT The authors concluded that the evidence generally supported the APT, but acknowledged that their tests were not conclusive