This action might not be possible to undo. Are you sure you want to continue?

Rahul Savalia Mithilesh Shukla

arbitrage will take place in which arbitrageurs buy the good which is cheap and sell the one which is higher priced till all prices for the goods are equal .Arbitrage Pricing Theory (APT) Based on the law of one price. Two items that are the same cannot sell at different prices If they sell at a different price.

the assumption of investors utilizing a meanvariance framework is replaced by an assumption of the process of generating security returns. APT requires that the returns on any stock be linearly related to a set of indices. multiple factors have an impact on the returns of an asset in contrast with CAPM model that suggests that return is related to only one factor.APT In APT. systematic risk . i..e. In APT.

. the bik terms determine how each asset reacts to this common factor. growth in GNP. or changes in interest rates ri = ai + bi1F1 + bi2F2 + «+bikFk + ei Given these common factors.Factors that have an impact the returns of all assets may include inflation. major political upheavals.

the impact will differ. zero-systematic risk portfolio is zero. when the unique effects are diversified away: E(ri) = P0 + P1bi1 + P2bi2 + « + Pkbik . Which firms will be affected more by the growth in GNP? The APT assumes that. the return on a zero-investment.While all assets may be affected by growth in GNP. in equilibrium.

Single Index Model-Assumptions Known economist William Sharpe developed the single index model. i. Stocks co vary together only because of their common relationship to the market index.e. there is no other source of correlation between securities. a) b) c) . all remaining uncertainty in stock return is firm specific. Beyond this common effect. According to this model we make following assumptions: We summarize all relevant economic factors by one macro-economic indicator and assume that it moves the security market as a whole.

A broad index of common stock is generally used for this purpose. . Nifty 50 stocks so on and so forth.Single Index Model This model relates returns on each security to the returns on a common index. The common index can be BSE 100 stocks.

Ri= the return on security i RM=the return on the market index part of security i·s return independent of market performance.Single Index Model. i=that . Ri. given a change in the independent variable RM ei= random residual error. i= a constant measuring the expected change in the dependent variable.Returns The single index model can be expressed by the following equation.

affecting an individual company but not all companies in general. on the other hand.Single Index Model. iRM marketThe unique part is a micro event. . The error term ei captures the difference between the return that actually occurs and return expected to occur given a market index return. Single index model divides return into two components a unique part. 2. i a market-related part. is a macro event that is broad based and affects all (or most) of the firms. The market related part.Returns 1.

=1 >1 <1 =0 stock has average risk. stock is less risky than average.g.0. Treasury bills) .. It shows the relative volatility of a given stock compared to the average stock. Beta shows how risky a stock is if the stock is held in a well-diversified portfolio.Measuring Systematic Risk Beta ( ) measures a stock·s market (or systematic) risk. stock is riskier than average. An average stock (or the market portfolio) has a beta = 1. risk free assets (e.

NO Wi2 Variance of return on market portfolio NO variance of return on stock i . the covariance between two stocks depends only on the market risk Therefore covariance between two securities can be written as Note that stock i·s beta has two components: Covariance of returns between stock i and market portfolio.Co variance In the single index model.Single Index Model.

Single Index Model.Risk In Single Index Model. the total risk of a security. as measured by its variance. consists of two components: market risk and unique risk = Market risk+ company specific risk .

Single Index Model. i. Total portfolio variance=Portfolio market risk+ portfolio residual variance .e.Risk This single security variance can be extrapolated for finding the minimum variance set of portfolios.

Reward to Risk Ratio We can vary the amount invested in each type of asset and get an idea of the relation between portfolio expected return and beta: Reward .to . We can also calculate the reward to risk ratio for all individual securities.Risk Ratio ! E ( RP ) R f FP It estimates the expected risk premium per unit of risk. .

Eventually. Here. ! E ( RM ) R f FM ! E ( RM ) R f . it would be A.. all securities will have the same reward-to-risk ratio.What happens if two securities have different reward-to-risk ratios? E (RA ) R f FA " E ( RB ) R f FB Investors would only buy the securities (portfolios) with a higher rewardto-risk ratio. Result: E ( RA ) R f FA ! E ( RB ) R f FB ! . it must hold for the market portfolio too.. Because the reward-to-risk ratio is the same for all securities.

Thank You .

Sign up to vote on this title

UsefulNot useful- Arbitrage Pricing Theory
- Arbitage Pricing Model
- Single Index Model
- Arbitrage Pricing Theory
- Ch16 Arbitrage Pricing Model
- Portfolio Theory- Sharpe Index Model
- Optimal Portfolio Jaggu Project
- Arbitrage Pricing Theory
- Markowitz Model
- Arbitrage Pricing Model
- Arbitrage Pricing Theory
- Arbitrage Pricing Theory
- Sharpe's Model
- markowitz model
- Comparison of CAPM & APT
- Project on Derivative Market
- Arbitrage Pricing Theory & Sharpe Index Model