CHAPTER TWELVE

ARBITRAGE PRICING
THEORY

1
 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

2
 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

3
 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

4
 FACTOR MODELS

• SECURITY PRICING
FORMULA:
ri = 0 + 1 b1 + 2 b2 +. . .+ KbK
where
ri = rRF +(1rRFbi12rRF)bi2+
rRFbiK
5
 FACTOR MODELS

where r is the return on security i

is the risk free rate
b is the factor
e is the error term

6
 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