Arbitrage Pricing Theory

Dr Saurabh Prasad
 Arbitrage Pricing Theory
 Arbitrage Pricing Theory was developed by Stephen Ross
(1976). His theory begins with an analysis of how investors
construct efficient portfolios and offers a new approach for
explaining the asset prices and states that the return on any
risky asset is a linear combination of various
macroeconomic factors that are not explained by this theory
namely.
 Like CAPM it assumes that investors are fully diversified,
and the systematic risk is an influencing factor in the long
run. However, unlike CAPM model APT specifies a simple
linear relationship between asset returns and the associated
factors because each share or portfolio may have a different
set of risk factors and a different degree of sensitivity to
each of them.
 APT Background
 Arbitrage pricing theory (APT) states that
several distinct factors determine the market
return
• Roll and Ross state that a security’s long-run
return is a function of changes in:
– Inflation
– Industrial production
– Risk premiums
– The slope of the term structure of interest rates
 APT Background (cont’d)
 Not all analysts are concerned with the
same set of economic information
• A single market measure such as beta does not
capture all the information relevant to the price
of a stock
 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
 Assumptions - 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
Arbitrage Pricing Theory (APT)
Rt  Et  bi1 i  bi 2 i  ...  bik  k   i
For i = 1 to N where:
Ri = return on asset i during a specified time period
= expected return for asset i
Ei
= reaction in asset i’s returns to movements in a common
bik factor
 k = a common factor with a zero mean that influences the
returns on all assets
= a unique effect on asset i’s return that, by assumption, is
 i completely diversifiable in large portfolios and has a
mean of zero
N = number of assets
 k
Multiple factors expected to have an impact on all assets
 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
 Arbitrage Pricing Theory (APT)
 APT assumes that, in equilibrium, the return
on a zero-investment, zero-systematic-risk
portfolio is zero when the unique effects are
diversified away.
THANK
YOU!!