# Arbitrage Pricing Theory

Prof Mahesh Kumar Amity Business School

Assumptions
1. 2. All investors can borrow or lend money at risk free rate of return. All investor have identical distributions for future rates of return i.e. they have homogenous expectations with respect to the three inputs of the portfolio model i.e. expected returns, the variance of returns and the correlation matrix. Therefore, given a set of security prices and a risk free rate, all investors use the same information to generate an efficient frontier. All the investors have the same one period time horizon. There are no transaction costs. There are no personal taxes- investors are indifferent between capital gains and dividend. There is no inflation. There are many investors, and no single investor can affect the price of the stock through his or her buying and selling decisions. Investors are price takers and are unaffected by their own trades. Capital Markets are in equilibrium

3. 4. 5. 6. 7.

8.

Shortcomings of CAPM
CAPM is based on highly restrictive assumptions. There are serious doubts about its testability. The market factor is not the sole factor influencing the stock returns.

Introduction
Arbitrage Pricing Theory (APT) was developed by Stephen A Ross in 1976. Like CAPM, APT also posits a relationship between expected return and risk however by using different assumptions and procedures. Unlike CAPM which predicts that only market risk influences expected returns, APT recognizes that several types of risk may affect security returns.

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 i.e. All investor have identical distributions for future rates of return i.e. they have homogenous expectations with respect to the three inputs of the portfolio model i.e. expected returns, the variance of returns and the correlation matrix. Therefore, given a set of security prices and a risk free rate, all investors use the same information to generate an efficient frontier.

Arbitrage Pricing Theory (APT)
Multiple factors expected to have an impact on all assets:  Inflation  Growth in GNP  Major political upheavals  Changes in interest rates  And many more«. Contrast with CAPM insistence that only beta is relevant

Arbitrage Pricing Theory (APT) 
Bik determine how each asset reacts to this common factor  Each asset may be affected by growth in GNP, but the effects will differ  In application of the theory, the factors are not identified  Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio

Hypothesis
APT is based on the law of one price, which states that two otherwise identical assets cannot sell at different prices. APT assumes that returns are linearly related to a set of indexes, where each index represents a factor that influences the return on the asset. They buy and sell securities so that, given the law of one price, securities affected equally by the same factors will have equal expected returns.

Hypothesis
The buying and selling is an arbitrage process, which determines the price of the securities. APT states that equilibrium market price will adjust to eliminate any arbitrage opportunities. If arbitrage opportunities arise, a relatively few investors can act to restore equilibrium.

Assumptions
Following are the assumptions made in APT a) Investors have homogenous beliefs b) The absence of taxes. c) Markets are perfect. d) Returns are generated by a factor model.

What is a factor model?
Factor model is used to depict the behavior of security prices by identifying major factors in the economy that affect large number of securities. These risk factors represent broad economic forces and by definition represent the element of surprise in the risk factor- the difference between the actual value for the factor and its expected value.

Characteristics of the factor
The factor must possess three characteristics: 1. Each risk factor must have pervasive influence on stock returns. Firm specific events are not APT risk factors. 2. The risk factors must influence expected returns. 3. At the beginning of each period, the risk factors must be unpredictable to the market as a whole.

Equilibrium Risk Return Relationship
The equilibrium relationship according to APT is as follows:

E(Ri) =a0+bi1F1+bi2F2+«««+binFn
E(Ri)= the expected return for security I a0= the expected return on a security with zero systematic risk F= the risk premium for a factor i.e. E(F1)-a0 Bin =sensitivity of stock i to risk factor n

Conclusion
APT is more general than CAPM. The problem with APT is that factors are not well specified. Roll and Ross through their empirical work suggested that three to five factors influence security returns. Changes in expected inflation. Unanticipated changes in inflation. Unanticipated changes in industrial production. Unanticipated changes in the default risk premium Unanticipated changes in the term structure of interest rates.

a) b) c) d) e)

Conclusion
According to APT, i) Different securities have different sensitivities to the systematic factors, and investor risk preferences are characterized by these dimensions. ii) Each investor has different risk attitudes. Investors could construct a portfolio depending upon desired risk exposure to each of these factors. iii) Knowing the market prices of these risk factors and sensitivities of securities to changes in the factors, the expected returns of various stocks could be estimated.

Arbitrage: ³The law of one price´
Arbitrage relies on a fundamental principle of finance : one price the law of 

says ± two identical securities must have the same price regardless of the means of creating that security.  implies ± if the payoff of a security can be synthetically created by a package of other securities, the price of the package and the price of the security whose payoff replicates must be equal.

Arbitrage ± Example
How can you produce an arbitrage opportunity involving securities A, B,C?

Security A B

Price £70 £60

Payoff in State 1 £50 £30

Payoff in State 2 £100 £120

C £80 £38 £112 Replicating Portfolio:  combine securities A and B in such a way that  replicate the payoffs of security C in either state Let wA and wB be proportions of security A and B in portfolio

Example Continued
Payoff of the portfolio

in state 1 : 50 w A  30 w B in state 2 : 100 w A  120 w B

Create a portfolio consisting of A and B that will reproduce the payoff of C regardless of the state that occurs one year from now.

50 wA  30wB ! 38 100wA  120wB ! 112
Solving equation system, weights are found wB = 0.6 and wA = 0.4

An arbitrage opportunity will exist if the cost of this portfolio is different than the cost of security C. Cost of the portfolio is 0.4 x £70 + 0.6 x £60 = £64 - price of security C is £80. The ³synthetic´ security is cheap relative to security C.

Example ± Continued
Riskless arbitrage profit is obtained by ³buying A and B´ in these proportions and ³shorting´ security C. Suppose you have £1m capital to construct this arbitrage portfolio. Investing £400k in A £400k z £70 = 5714 shares Investing £600k in B £600k z £60 = 10,000 shares Shorting £1m in C £1m z £80 = 12,500 shares

Example ± Continued
The outcome of forming an arbitrage portfolio of £1m
Security Investment A B C Total -400000 -600000 1000000 £0 State 1 5714 x 50 = 285700 10000 x 30 = 300000 State 2 5714 x 100 = 571400 10000 x 120 =1200000

12500 x 38 = -475000 12500 x 112 = -1400000 £110,700 £371,400

The Arbitrage Pricing Theory
CAPM is criticised for two assumptions:  The investors are mean-variance optimizers  The model is single-period Stephen Ross developed an alternative model based purely on arbitrage arguments Published Paper:

³The Arbitrage Pricing Theory of Capital Asset Pricing´, Journal of Economic Theory, Dec 1976.

APT versus CAPM
APT is a more general approach to asset pricing than CAPM. CAPM considers variances and covariance's as possible measures of risk while APT allows for a number of risk factors. APT postulates that a security¶s expected return is influenced by a variety of factors, as opposed to just the single market index of CAPM APT in contrast states that return on a security is linearly related to ³factors´. APT does not specify what factors are, but assumes that the relationship between security returns and factors is linear.

FACTOR MODELS
ARBITRAGE PRICING THEORY (APT)  is an equilibrium factor mode of security returns  Principle of Arbitrage the earning of riskless profit by taking advantage of differentiated pricing for the same physical asset or security  Arbitrage Portfolio requires no additional investor funds no factor sensitivity has positive expected returns

FACTOR MODELS
ARBITRAGE PRICING THEORY (APT)  Three Major Assumptions: capital markets are perfectly competitive investors always prefer more to less wealth price-generating process is a K factor model

FACTOR MODELS
MULTIPLE-FACTOR MODELS  FORMULA ri = ai + bi1 F1 + bi2 F2 +. . . + biKF K+ ei where r is the return on security i b is the coefficient of the factor F is the factor e is the error term

FACTOR MODELS
SECURITY PRICING FORMULA:
ri = P0 + P1 b1 + P2 b2 +. . .+ PKbK where ri = rRF +(H1rRF bi1  H2 rRF)bi2+  HrRF biK

where

r P b e

is the return on security i is the risk free rate is the factor is the error term

FACTOR MODELS
hence  a stock¶s expected return is equal to the risk free rate plus k risk premiums based on the stock¶s sensitivities to the k factors