Presentation of “Portfolio Management”

Topic = “Arbitrage Pricing Theory ”

MBA (FC) 4th sem.

Presented By
Group No:- 7
Under Guidance of
Priya singh
Dr. Shruti Mishra
Kumud Sagar
Parul Sachan
Rajesh Babu Katiyar
 Learning Objectives

Arbitrage
Factor Model
Arbitrage Pricing Theory
Types of Arbitrage
Multi-factor Model
Behavioral Finance
Arbitrage
Buy from the
low priced
market and
selling at the
high priced
market to earn
profit
 EXAMPLE

As a simple example of arbitrage, consider the
following. The stock of Company X is trading at $20 on
the New York Stock Exchange (NYSE) while, at the
same moment, it is trading for $20.05 on the London
Stock Exchange (LSE). A trader can buy the stock on the
NYSE and immediately sell the same shares on the LSE,
earning a profit of 5 cents per share. The trader could
continue to exploit this arbitrage until the specialists on
the NYSE run out of inventory of Company X's stock, or
until the specialists on the NYSE or LSE adjust their
prices to wipe out the opportunity.
 FACTOR MODEL

The CAPM provides a link between expected returns
on a share and the expected returns on market index.
The essence of CAPM is that investors will be
rewarded for only non diversifiable risks. These non-
diversifiable risks can be traced to macroeconomic
factors. Some examples are: interest-rates, inflation,
gross national product, balance of payments, foreign
exchange reserves etc.
 The Arbitrage Pricing
Theory

 A strategy that makes a positive return without
requiring an initial investment.
In other words: arbitrage opportunities exist when
two items that are the same sell at different prices.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.
Cont…

The APT investigates the market equilibrium
prices when all arbitrage opportunities are
eliminated.
The APT implies a linear equilibrium relationship
between expected return and the factor
sensitivities (betas)
 The APT: Assumptions

Perfect competitive capital market
All investors have homogeneous expectations,
regarding mean, variance and covariance
More wealth is preferred to less (but no need to
know for risk attitudes)
Large number of capital assets exist
Short sales are allowed
 Cont…

 The expected return on a security under the APT with a
single factor is given (precisely as by SML) by:

 The expected return on a security under the APT with

multiple factors is given by:
 TYPES OF ARBITRAGE

 Risk Arbitrage
 Triangular Arbitrage
 Fixed Income Arbitrage
 Spatial Arbitrage
 Futures Spread
 Telecom Arbitrage
 Risk Arbitrage

Risk arbitrage, also known as merger
arbitrage, is a hedge fund investment strategy,
that speculates on the successful completion
of mergers and acquisitions.
 Triangular Arbitrage

Triangular arbitrage (also referred to as cross-
currency arbitrage or three-point arbitrage) is
the act of exploiting an arbitrage opportunity
resulting from pricing discrepancy among
three different currencies in foreign exchange
market.
 Fixed Income Arbitrage

An investment strategy that attempts to
profit from arbitrage opportunities in
interest rate securities. When using a
fixed-income arbitrage strategy, the
investor assumes opposing positions in
the market to take advantage of small
price discrepancies while limiting interest
rate risk.
 Spatial Arbitrage

Also known as Geographical Arbitrage, this is
the simplest form of arbitrage. In Spatial
arbitrage, an arbitrageur looks for price
difference between geographically separate
markets.
 Futures Spread

An arbitrage technique in which a trader buys
one commodity and sells another contract of
the same commodity to capitalize on a
discrepancy in prices. In futures spread, the
goal is to profit from the change in the price
difference between two futures contracts
while hedging against risk.
 Telecom Arbitrage

An arbitrage strategy used by
telecommunications companies that enables
their mobile or cellular phone customers to
make international calls without paying long-
distance charges by dialing certain access
numbers.
 Multi-Factor Model

A multi-factor model is a financial model that
employs multiple factors in its calculations to
explain market phenomena and/or equilibrium asset
prices. The multi-factor model can be used to
explain either an individual security or a portfolio of
securities. It does so by comparing two or more
factors to analyze relationships between variables
and the resulting performance.
 Behavioral Finance

Behavioral finance is the study of the influence of
psychology on the behavior of investors or financial
practitioners and ultimately, the subsequent effect on
the markets. It focuses on the fact that investors are
not always rational, have limits to their self-control,
and are influenced by their own biases.
Behavioral Finance Theory

Traits of behavioral finance are:

 Investors are treated as “normal” not “rational”

 Investors actually have limits to their self-control
 Investors are influenced by their own biases
 Investors make cognitive errors that can lead to wrong
decisions
Decision-Making Errors and Biases
 Self-Deception

The concept of self-deception is a limit to the way
we learn. By tricking ourselves into thinking we
know more than we do, we are closed off to
information that we need to make an informed
decision.
 Heuristic Simplification

We can also scope out a bucket that is often
referred to as heuristic simplification. In
other words, it is heuristic simplification is
information-processing errors.
 Emotion

We can also scope out a bucket that’s related to
emotion, but we’re not going to dwell on this bucket
in this introductory session. However, I’m sure we
all have experiences where our decisions have been
influenced by whether we’re angry, sad, happy, and
so on. That’s really what we are getting at – how
mood affects our decision making.
 Social Influence

In this final bucket, we will talk about the
social bucket. What we mean by the social
bucket is how our decision making is
influenced by others.
 BIBLIOGRAPHY

Pioneering Portfolio Management:
by David F. Swensen
Active Portfolio Management:
by Richard Grinold & Ronald Kahn
Sources:-
www.google.com

Total number of slides:- 26