Arbitrage Pricing

Theory
RAVICHANDRAN
 Arbitrage Pricing Theory

An asset pricing model based on the idea that an asset's returns can be
predicted using the relationship between that same asset and many
common risk factors.
Created in 1976 by Stephen Ross, this theory predicts a relationship
between the returns of a portfolio and the returns of a single asset
through a linear combination of many independent macro-economic
variables.
 APT
• The arbitrage pricing theory (APT) 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.
 APT
• 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 over priced 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.
 Macro Economic factors for APT
model
• surprises in inflation;
• surprises in GNP as indicated by an industrial production index;
• surprises in investor confidence due to changes in default premium in
corporate bonds;
• surprise shifts in the yield curve.
Market Indices - Calculation
As a practical matter, indices or spot or futures market prices may be used in
place of macro-economic factors
• Market indices are sometimes derived by means of factor analysis. More direct
"indices" that might be used are:
• short-term interest rates;
• the difference in long-term and short-term interest rates;
• a diversified stock index such as the S&P 500 or NYSE Composite;
• oil prices
• gold or other precious metal prices
• Currency exchange rates
 APT and CAPM
The APT is an alternative model to the CAPM.
It makes fewer assumptions, and as a result gets weaker predictions. In
particular, the APT does not say what the systematic factors are, whereas the
CAPM says that the market portfolio is the only systematic source of risk.
Later: How to specify the factors?
a) Factors can be specified a priori: they could be macroeconomic variables
(ex inflation, output) that capture the systematic risk in the economy or
portfolios proxying for these risks.
b) b) Factors can be extracted via Principal Components or Factor Analysis.
APT formula

• Risk-free rate (Rf) the yield of ten years government bond.

• Beta (Bn): the sensitivity or “correlation” to the volatility of a particular risk factor (Rfn).
Also : Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n)
• In terms this equation, calculates the portfolio’s expected returns (Er) in
relationship with the particular grouping of independent economic indicators.
• The most important type of economic indicators are the leading ones; which
will change before the business cycle changes. The best leading economic
indicator is the stock market itself, S&P 500.
• The APT model also states the risk premium of a stock depends on two factors:
• The risk premiums associated with each of the factors described above
• The stock's own sensitivity to each of the factors; similar to the beta concept
• Risk Premium = r - rf = b(1) x (r factor(1) - rf) + b(2) x (r factor(2) - rf)... + b(n) x
(r factor(n) - rf)
• If the expected risk premium on a stock were lower than the
calculated risk premium using the formula above, then investors
would sell the stock.
• If the risk premium were higher than the calculated value, then
investors would buy the stock until both sides of the equation were in
balance.
• Arbitrage is the term used to describe how investors could go about
getting this formula, or equation, back into balance
APT versus the Capital Asset
Pricing Model
• As mentioned, the Arbitrage Pricing Theory and the
Capital Asset Pricing Model (CAPM) are the two most influential
theories on stock and asset pricing today. The APT model is different
from the CAPM in that it is far less restrictive in its assumptions. APT
allows the individual investor more freedom to develop a model that
explains the expected return for a particular asset.
• Intuitively, the APT makes a lot of sense because it removes the CAPM
restrictions, and basically states "The expected return on an asset is a
function of many factors as well as the sensitivity of the stock to these
factors." As these factors move, so does the expected return on the
stock, and therefore its value to the investor.
APT versus the Capital Asset
Pricing Model
• In the CAPM theory, the expected return on a stock can be described
by the movement of that stock relative to the rest of the market. The
CAPM is really just a simplified version of the APT, whereby the only
factor considered is the risk of a particular stock relative to the rest of
the market, as described by the stock's beta.
• From a practical standpoint, CAPM remains the dominant pricing
model used today. When compared to the Arbitrage Pricing Theory,
the Capital Asset Pricing Model is both elegant and relatively simple
to calculate.
 APT - Mechanics

• Arbitrage is the practice of taking positive expected return from overvalued or

undervalued securities in the inefficient market without any incremental risk and zero
additional investments.
• In the APT context, arbitrage consists of trading in two assets – with at least one being
mispriced.
• The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to
buy one which is relatively too cheap.
• Under the APT, an asset is mispriced if its current price diverges from the price predicted
by the model.
• The asset price today should equal the sum of all future cash flows discounted at the APT
rate, where the expected return of the asset is a linear function of various factors, and
sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
• When the investor is long the asset and short the portfolio (or vice
versa) he has created a position which has a positive expected return
(the difference between asset return and portfolio return) and which
has a net-zero exposure to any macroeconomic factor and is therefore
risk free (other than for firm specific risk).
• The arbitrageur is thus in a position to make a risk-free profit:
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

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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

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FACTOR MODELS
• SECURITY PRICING
FORMULA:

ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK
where
ri = rRF +(d1-rRF )bi1 + (d2- rRF)bi2+ . . .
+(d-rRF)biK

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FACTOR MODELS

where r is the return on security i

l0 is the risk free rate
b is the factor
e is the error term

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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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 Case
• Joey did an investment analysis for stock X. The results of the analysis
are as follows. The market price of risks (bi) and sensitivities for the
particular stock is given below.
• Rf = 5%

• The probability of getting a return on stock X is given above.

• Can an investor purchase stock x?
• The expected return of the stock X
• ri = l0 + l1 b1 + l2 b2+ + l3 b3 + l4 b4
• = 5 + (.9*0.9) + (.9*1.8) + (1.3 *1.6)+ 0.8*-.1.75)
• = 8.11
• The probable return = (15*0.4) + (20*0.3)+(10*0.2)+(8*0.1)
• =14.8
• Since the probable return is higher than the return according to the
model, stock X can be purchased.