Arbitrage Pricing Theory

Arbitrage is a process of earning profit by taking advantage of

differential pricing for the same asset. The process generates
riskless profit. In the security market, it is of selling security at a
high price and the simultaneous trurcha of the same security at a
relatively lower price. Since the profit earned through arbitrage
is riskless the investors have the incentive to undertake this
whenever an opportunity arises. The arbitrage us thus reduce
and eliminate. The profit margin bringing the market price to the
equilibrium level.

Its assumptions vis- a- vis those of CAPM are set out below :
APT

CAPM

Investors do not look at

Investors look at expected

expected returns and standard returns and accompanying

deviations

risks measured by SD

Risk-Return Analysis is not

Investors are risk- averse and

the basis.

risk- return analysis is necessary

Investors prefer higher Wealth/ Investors maximise wealth for a

return to lower wealth
given level of risk

APT is based on the return

generated by factor models.

Factor

Beta

Expected value

Actugal value

GNP

1.95

6.00%

6.50%

Inflation

0.85

5.00%

5.75%

Intervetsvate 1.20

7.00%

8.00%

Stock market 2.50

9.50%

11.50

9.00%

10.00%

Index
Industrial
Production

2.20

The risk- free (articipated) rate of return is on the Divine share

is 9%. How much is the total return on the share.
The total return will consist of anticipated (risk- free) return and
unanticipated return.
=9+ ( 6.5-6)1.95 + (5.75-5)0.85+(8-7) 1.20
+ (11.5-9.5) 2.50+(10-9)2.20

=9+10 = 19%
The beta of a factor is the sensitivity of the assets return to the
changes in the factor.

Arbitrage Portfolio
According to the APT an investor tries to find out the
possibility to increase returns from his portfolio without
increasing the funds in his portfolio. He also likes to keep the
risk at the same level. For example, the investor holds A,B&C
securities and he wants to change the proportion of the
securities without any additionalfinancila commitment. Now
the change in porfortion of secutities can be denoted by xa, xb
& xc. The increase in the investment in security A could be
carried out only if he reduces the propotion of investmnet
either in B or C because it has already been stated that the
investor tries to earn more income wihtout increasing his
financila commitment. Thus the chnages in different securities
will add up to zero. This is the basic requirement of an
arbitrage portfolio.

If x indicates the change in proportion

Xa+ xb+ xc=0
The factor sensitivity indicates the responsiveness of a securitys
return to a particular factor. The sensitiveness of the securities to
any facotr is the weightes average of the sensitiveness of the
securities the chnages made in the proportions.
For example ba, bb and bc are the sensitivities in an arbitrage
portfolio the sensitivities become zero.
Ba xa + ba xb+ bc x c=0
The investor holds the A, B & C stocks with the following
retruns and sensitivity to change in the industrial production.
The total amount invested is Rs. 150,000.

Original weights

Stock A

20%

.45

.33

Stock B

15%

1.35

.33

Stock C

12%

.55

.34

Now the proportions are changed. The changes are

X A=.2
X B=.025
Xc= -.225

For an arbitrage portfolio

X A+ xB+ xC=0
.2+.025-.225=0

The sensitivities also become zero.

xAbA+xBbB+xcB=0
.2x.45+.025x1.35-.225x.55=0
In an arbitrage portfolio, the expected return should be greater
than zero.
xA Ra+ xBRB+xcRc>0
.2x20+.025x15-.225x12
4.375-2.7>0

i.e. 1.675%

The investor would increase his investment in stock A and B

selling C. the new composition of weight is :
X A = 0.53

X B= 0.355
X C = 0.115
The portfolio allocation on stock A, B & C is an follows:

= 150,000x.53+150,000x.355+150,000x.115
=Rs.79,500+53,250+17,250
The sensitivity of the new portfolio will be
= . 45x.53 +1.35x.355+.55x.115
=. 239+.479+.063

= .781

This is same as the old portfolio sensitivity

i.e; .45 x .33 + 1.35 x .33 + .55 x .34 =. 781
The return of the new portfolio is higher than the old portfolio.
Old portfolio retrun
= 20 x .33 + 15x .33 + 12x .34
= 6.6 + 4.95+4.08

= 15.63%
The new portfolio retrun
=20x.53 + 15x. 355 + 12x .115
= 10.6+5.325+1.38
=17.305%

This is equivalent to the old portfolio return plus the return

that occurred due to the change in portfolio.
= 15.63% + 1.675%

=17.305%
The variable of the new portfolios change is only due to the
chnages in its non-factor risk. Hence, the change in the riks
factor is negbigible. Form the analysis it can be concluded
that
i.The arbitrage and old portfoliois higher than the old
portfolio.
ii.The arbitrage and old portfolio sensitivity remains the
same.

iii. The non-factor risk is small enough to be ignored in an

arbitrage portfolio.
Effect on Price. To buy stock A & B, the investor has to sell
stock. The buying pressure on stock A & B would lead to
increase in their prices. Conversely selling of stock c will result
in fall in the price of the stock c. with the low price there would
be rise in the expected return of stock c. for example if the stock
c at price Rs. 100 per share have earned 12% return, at Rs. 80
per share, the return would be 12/80x100=15%. At the same
time return rates would be declining in stock A & B with the rise
in price. This buying and selling activity will countinue untill all
arbitrage possibilities are eliminated. At this juncture, these
exists an approximate linear relationship between expected
returns and sensitivities.