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Arbitrage Pricing Theory

Prof Mahesh Kumar


Amity Business School
Assumptions
1. All investors can borrow or lend money at risk free rate of return.
2. 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.
3. All the investors have the same one period time horizon.
4. There are no transaction costs.
5. There are no personal taxes- investors are indifferent between
capital gains and dividend.
6. There is no inflation.
7. 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.
8. Capital Markets are in equilibrium
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.
a) Changes in expected inflation.
b) Unanticipated changes in inflation.
c) Unanticipated changes in industrial production.
d) Unanticipated changes in the default risk premium
e) Unanticipated changes in the term structure of
interest rates.
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: “The law of one price”

Arbitrage relies on a fundamental principle of finance : the law of


one price
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?


Payoff in Payoff in
Security Price
State 1 State 2
A £70 £50 £100
B £60 £30 £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 wA  30 wB


in state 2 : 100wA  120wB
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  120 wB  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 “synthetic” security is cheap relative to security C.
Example – Continued

Riskless arbitrage profit is obtained by “buying A and B” in


these proportions and “shorting” security C.
Suppose you have £1m capital to construct this arbitrage
portfolio.
Investing £400k in A £400k  £70 = 5714 shares
Investing £600k in B £600k  £60 = 10,000 shares
Shorting £1m in C £1m  £80 = 12,500 shares
Example – Continued

The outcome of forming an arbitrage portfolio of £1m

Security Investment State 1 State 2


A -400000 5714 x 50 = 285700 5714 x 100 = 571400
B -600000 10000 x 30 = 300000 10000 x 120 =1200000
C 1000000 12500 x 38 = -475000 12500 x 112 = -1400000
Total £0 £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:
“The 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 “factors”.
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 = 0 + 1 b1 + 2 b2 +. . .+ KbK
where
ri = rRF +(1rRFbi12rRF)bi2+rRFbiK
where r is the return on security i
is the risk free rate
b is the factor
e 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

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