Arbitrage Pricing Theory, CAPM and Multifactor Models

Submitted By: Group No. 9 Arpit Sharma 141 Ritesh Jain 148 Sagar Gupta

Objectives of the study

To understand the concept of Arbitrage and how it is used in developing Arbitrage Pricing Theory(APT) To get the insights of Capital Asset Pricing Model(CAPM) and analyze its relationship with APT To understand the applications and to identify the anomalies in such theories

Project Outline
A one-factor model is one under which there is a single, one dimensional source of randomness affecting bond process( for example one dimensional Brownian motion). Under such a model all price changes are perfectly(but non-linear) correlated. In other words, if we know the change in one quantity(for example the risk free rate) then we know the change in the prices of all assets. A multi factor model is one under which there is more than one source of randomness. Then we find that price changes are not perfectly correlated. The drivers under a two factor model might be two dimensional Brownian motion and these may be used, for example, to drive the short term rate and its volatility, or the short rate and the rate of interest on irredeemable bonds. If there are n factors, then the changes in the prices of n bonds will be sufficient for us to know the changes in the prices of all other bonds. The capital asset pricing model (CAPM), which is a single factor model, is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM suggests that an investors cost of equity capital is determined by beta. The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

The arbitrage pricing theory (APT), which is a multi factor model, describes the price where a mispriced asset is expected to be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors. Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. A mispriced security will have a price that differs from the theoretical price predicted by the model. By going short an overpriced security, while concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in a position to make a theoretically risk-free profit. Main advantage of APT is that its empirical testability does not hinge upon knowledge of the market's portfolio.

Relationship between the CAPM and APT

The two models approach asset pricing from different aspects. The APT is less restrictive in its assumptions than the CAPM. It is a rather explanatory model as opposed to statistical. It assumes investors will each hold a portfolio unique to their risk receptiveness with a unique beta, as opposed to the identical market portfolio presumed by the CAPM. Moreover, the APT presumes an infinite number of investments, which in turn lead to the disappearance of firm-specific risk. It can be viewed as a supply-side model, as its beta coefficients reflect sensitivity of the underlying asset to the different factors. In this sense, factor changes will cause sizable shifts in the assets expected retu rns. On the other hand, the CAPM is a demand-side model. Its results arise from the investors utility function maximisation problem, and from the resultant market equilibrium. As investors can be considered to be consumers of the asset, the demand approach is reasonable.

Applications
These theories lend themselves to various practical applications due to their simplicity and flexibility. The three areas of applications critically reviewed here are: asset allocation, the computation of the cost of capital, and the performance evaluation of managed funds.

Anomalies in Such Theories

Researchers recognised the existence of asset mispricing that surpassed available economic theories ability to explain them, the study of anomalies began. It is always easier to determine the causes of the occurrences with the benefit of hindsight. But when they are actually taking place, it is not easy to identify them, let alone incorporate them into pricing models. This is the benefit market speculators get for their efforts in identifying anomalies. When an anomaly gets detected, and enough arbitrageurs have made money, as the self-fulfilling prophecy foretells us, the trend disappears. This is when the anomaly is ripe for public introduction and the race begins for providing extensive analysis in financial journals. Amongst the reasons for anomalies are: tax evasion, window-dressing of portfolio fund managers, or expected premium for trading opposite positions to insiders. Here, I introduce the most famous anomalies that prevailed in the past decades.