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Arbitrage pricing theory (APT) holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient. The model derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by model. If the price diverges, arbitrage should bring it back into line. The theory was initiated by the economist Stephen Ross in 1976. Based on the law of one price. Two items that are the same cannot sell at different prices. If they sell at a different price, arbitrage will take place in which arbitrageurs buy the good which is cheap and sell the one which is higher priced till all prices for the goods are equal.

The APT has a number of benefits. First, it is not as a restrictive as the CAPM in its requirement about individual portfolios. It is also less restrictive with respect to the information structure it allows. The APT is a world of arbitrageurs and vendors of information. It also allows multiple sources of risk, indeed these provide an explanation of what moves stock returns. The benefits also come with drawbacks. The APT demands that investors perceive the risk sources, and that they can reasonably estimate factor sensitivities.

Three Major Assumptions: Capital markets are perfectly competitive. Investors always prefer more to less wealth. Price-generating process is a K factor model. In APT, the assumption of investors utilizing a mean-variance framework is replaced by an assumption of the process of generating security returns. APT requires that the returns on any stock be linearly related to a set of indices. In APT, multiple factors have an impact on the returns of an asset in contrast with CAPM model that suggests that return is related to only one factor, i.e., systematic risk

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Factors that have an impact the returns of all assets may include inflation, growth in GNP, major political upheavals, or changes in interest rates ri = ai + bi1F1 + bi2F2 + +bikFk + ei Given these common factors, the bik terms determine how each asset reacts to this common factor.

APT along with the Capital asset pricing model (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions. It allows for an explanatory model of asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM can be considered a "special case" of the APT in that the Securities market line represents a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. Additionally, the APT can be seen as a "supply side" model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause structural changes in the asset's expected return, or in the case of stocks, in the firm's profitability.

Arbitrage pricing theory does not explicitly state the relevant macro economic factors; it has been observed that the following factors tend to influence the price of the security under consideration. Change in industrial production or GDP. Unanticipated inflation or deflation. Shifts in the Yield Curve. Investor confidence measured by surprises in default risk premiums for bonds.

Arbitrage pricing theory specifies asset (stock or portfolio) returns as a linear function of the aforementioned factors. APT gives the expected return on asset i as: E(Ri) = Rf + b1*(E(R1) - Rf) + b2*(E(R2) - Rf) + b3*(E(R3) - Rf) + + bn*(E(Rn) - Rf)

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Rf = Risk free interest rate (i.e. interest on Treasury Bonds) bi = Sensitivity of the asset to factori E(Ri) - Rf) = Risk premium associated with factori where i = 1, 2,...n The APT model also states that 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.

A perfectly competitive market is one where any trader can buy or sell unlimited quantities of the relevant security without changing the security s price. In an arbitrage portfolio-a set of goods held by an owner in an economy conform to the APT conditions-the investor tries to increase the returns from his portfolio without increasing fund in the portfolio, without spending other money. Moreover, he also likes to keep the risk at the same level. To do so, if the investor got in his portfolio A, B and C securities, to increase returns from his portfolio without further investing he will have to change the proportion of the securities. This means that if A earns him more he will tend to convert B and C in A before spending further money to buy A. Moreover, conversion may occur also to keep the risk constant as B and C might become too risky whereas A becomes less risky to keep.

Consider the following 2 portfolios:

Portfolio

E(rp)

bP

A B

20% 10%

1.5 1.0

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Where E (rp) is the expected return of the portfolio and bP is the portfolio beta. Both portfolios should have equal lambda factors, which can be found by solving for them simultaneously: 1. 0 + 1(1.5) = 20% 2. 0 + 1(1.0) = 10% 3. 1(0.5) = 5% 4. 1 = 10% 5. Substituting Equation 4 into Equation 1, we find: 6. 0 + 0.1(1.5) = 20% 7. 0 = 20% - 15% = 5% From this, we find the equilibrium APT equation: E (rp) = 5% + 10 %( bp) Now consider a portfolio C where E (rP) = 20% and bP = 1.2. Since portfolio C yields the same as A, but has a reduced risk factor as evidenced by its lower beta, an arbitrage profit should be possible. 1. Construct a portfolio from A and B that has the same risk as portfolio C: 2. bC = yA(bA) + (1 - yA)(bB) -> yA + yB = 1 3. 1.2 = yA(1.5) + (1 - yA)(1.0) 4. 1.2 = 1.5yA + 1 - yA 5. 1.2 = 1 + 0.5yA 6. 0.2 = 0.5yA -> Subtracted 1 from both sides. 7. 0.4 = yA -> Divide both sides by 0.5 8. Amount of portfolio B must be 0.6, since the proportions of both portfolios must sum to 1. 9. Now construct a portfolio D that has the same risk factor as portfolio C: 10. E(rD) = .4(rA) + .6(rB) 11. E(rD) = .4(20%) + .6(10%) = 8% + 6% = 14%

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REFERENCES: www.investopedia.com Dictionary www0.gsb.columbia.edu/faculty/.../APT-Huberman-Wang.pdf www.investorwords.com/247/Arbitrage_Pricing_Theory.html www.hjventures.com/valuation/Arbitrage-Pricing-Theory.html www.wikicfo.com/wiki/.../Arbitrage%20Pricing%20Theory.ashx www.narachinvestment.com/the_arbitrage_pricing_theory.html www.fxwords.com/a/arbitrage-pricing-theory.html www.finance-lib.com/financial-term-arbitrage-pricing-theory-apt.html www.highbeam.com/doc/1O18-arbitragepricingtheory.html

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