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PORTFOLIO MANAGEMENT

ARBITRAGE PRICING THEORY


MEMBERS

1. 2. 3. 4.

SHAJINA M V MITHUN T SRAVANA RAVI NIMISHA

ARBITRAGE PRICING THEORY

An asset pricing model

Developed by Stephen Ross in 1976 It is based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors 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. In plain language, arbitrage is the process of earning profit by taking advantage of differential pricing for the same asset.

Arbitrage Pricing Theory applies to economies that are regulated by the Law of One Price. The Law of One Price states that two identical goods cant but be sold with the same price. If they sell at different price arbitrage takes up.

ASSUMPTIONS
1.

Capital Markets are perfectly competitive.


A perfectly competitive market is one where any trader can buy or sell unlimited quantities of the relevant security without changing the securitys price

2.

Investors always prefer more wealth to less wealth. Perfect competition prevails and there is no transaction cost in the market

3.

Two models of arbitrage pricing theory:

Two Factor Model, according to Stephen Ross, returns of the securities are influenced by a number of macro economic factors. Among these: growth rate of industrial production, rate of inflation, spread(variability) between short term and long term interest rates and spread(variability) between long-grade and high-grade bonds. According to the Single Factor Model the return is influenced only by the sensitivity, i.e., the responsiveness of a securitys return to a particular factor.