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Q. 1 Is there any logic behind technical analysis? Explain meaning and basic tenets of technical
analysis.
Ans:
No, there is no logic behind technical analysis. Technical analysis is based on the assumption that
markets are driven more by psychological factors than fundamental values.
While fundamental analysts examine earnings, dividends, new products, research and the like,
technical analysts examine what investors fear or think about those developments and whether or not
investors have the where with all to back up their opinions; these two concepts are called psych
(psychology) and supply/demand. In the M = P/E equation, technicians assess M, the multiple investors
do/may pay - if they have the money - for the fundamentals they envision. Technicians employ many
techniques, one of which is the use of charts. Using charts, technical analysts seek to identify price
patterns and trends in financial markets and attempt to exploit those patterns. Technicians use various
methods and tools, the study of price charts is but one.
Supply/demand indicators monitor investors' liquidity; margin levels, short interest, cash in brokerage
Accounts, etc., in an attempt to determine whether they have any money left. Other indicators monitor
The state of psych - are investors bullish or bearish? - And are they willing to spend money to back up
their beliefs. A spent-out bull cannot move the market higher, and a well heeled bear won't; investors
need to know which they are facing. In the end, stock prices are only what investors think; therefore
determining what they think is every bit as critical as an earnings estimate.
Technicians using charts search for archetypal price chart patterns, such as the well-known head and
Shoulders or double top/bottom reversal patterns, study indicators, moving averages, and looks for
forms
Such as lines of support, resistance, channels, and more obscure formations such as flags, pennants,
Balance days and cup and handle patterns.
Technical analysts also widely use market indicators of many sorts, some of which are mathematical
Transformations of price, often including up and down volume, advance/decline data and other inputs.
These indicators are used to help access whether an asset is trending, and if it is, its probability of its
Direction and of continuation. Technicians also look for relationships between price/volume indices and
Market indicators. Examples include the relative strength index, and MACD. Other avenues of study
Include correlations between changes in options (implied volatility) and put/call ratios with price. Also
Important are sentiment indicators such as Put/Call ratios, bull/bear ratios, short interest and Implied
Volatility, etc.
There are many techniques in technical analysis. Adherents of different techniques (for example,
Candlestick charting, Dow Theory, and Elliott wave theory) may ignore the other approaches, yet many
traders combine elements from more than one technique. Some technical analysts use subjective
judgment to decide which pattern(s) a particular instrument reflects at a given time, and what the
interpretation of that pattern should be. Others employ a strictly mechanical or systematic approach to
pattern identification and interpretation.
Technical analysis is frequently contrasted with fundamental analysis, the study of economic factors
that influence the way investor’s price financial markets. Technical analysis holds that prices already
reflect all such trends before investors are aware of them. Uncovering those trends is what technical
indicators are designed to do, imperfect as they may be. Fundamental indicators are subject to the
same limitations, naturally. Some traders use technical or fundamental analysis exclusively, while
others use both types to make trading decisions which conceivably is the most rational approach.
Users of technical analysis are often called technicians or market technicians. Some prefer the term
Technical market analyst or simply market analyst. An older term, chartist, is sometimes used, but as
the discipline has expanded and modernized, the use of the term chartist has become less popular, as
it is only one aspect of technical analysis.
i) Technical analysis identifies non- random price patterns and trends in financial markets and
attempt to exploit those patterns.
ii) Unlike fundamental analysts, technical analysts do not care whether a stock is undervalued or
not – the only thing that matters to them is a security’s past trading data and what information this data
can provide about where the security is moving in the future.
iii) Technical analysis disregards the financial statements of the issuer. Instead it relies upon
market trends to ascertain investor sentiments that can be used to predict how a security will perform.
Below are the three basic tenets of the technical analysis: 1) the market discounts everything 2) price
moves in trends and 3) history trends to repeat itself.
i) Technical analysis assumes that any given point of time, a security’s price incorporates all the factors
that can impact the price including the fundamental factors.
ii) Technical analysts believe that the company’s fundamentals, along with broader economic factors
and market psychology are all built into the security price and therefore there is no need to study these
factors separately.
i) Technical analysis believes that security prices tend to move trends that persist for long periods of
time.
ii) Any shifts in supply & demand cause reversals in trends. These shifts can be detected in charts /
graphs.
Q.2 Explain role played by efficient market in economy. Apply the parameters of efficient market to
Indian stock markets and find out whether they are efficient.
Answer:
1In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "information ally
Efficient". That is, one cannot consistently achieve returns in excess of average market returns on a
risk adjusted basis, given the information publicly available at the time the investment is made.
There are three major versions of the hypothesis: "weak", "semi-strong", and "strong". Weak EMH
claims
Those prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly
available
Information. Semi-strong EMH claims both that prices reflect all publicly available information and that
Prices instantly change to reflect new public information. Strong EMH additionally claims that prices
instantly reflect even hidden or "insider" information. There is evidence for and against the weak and
Semi-strong EMHs, while there is powerful evidence against strong EMH.
The performance of a financial market depends on how efficiently the capital is allocated by the market.
The validity of the hypothesis has been questioned by critics who blame the belief in rational markets
for
Much of the financial crisis of 2007–2010. Defenders of the EMH caution that conflating market stability
With the EMH is unwarranted; when publicly available information is unstable, the market can be just as
Unstable.
The (now largely discredited) theory that all market participants receive and act on all of the
Relevant information as soon as it becomes available. If this were strictly true, no investment strategy
would be better than a coin toss. Proponents of the efficient market theory believe that there is perfect
Information in the stock market. This means that whatever information is available about a stock to one
Investor is available to all investors (except, of course, insider information, but insider trading is illegal).
Since everyone has the same information about a stock, the price of a stock should reflect the
knowledge
And expectations of all investors. The bottom line is that an investor should not be able to beat the
market since there is no way for him/her to know something about a stock that isn't already reflected in
the stock's price. Proponents of this theory do not try to pick stocks that are going to be winners;
instead,
they simply try to match the market's performance. However, there is ample evidence to dispute the
basic claims of this theory, and most investors don't believe it.
Studies on Indian Stock Market Efficiency: The efficient market hypothesis is related to the random
Walk theory. The idea that asset prices may follow a random walk pattern was introduced by Bachelier
in
1900. The random walk hypothesis is used to explain the successive price changes which are
independent
Of each other. Fama (1991) classifies market efficiency into three forms - weak, semi-strong and
strong.
In its weak form efficiency, equity returns are not serially correlated and have a constant mean. If
market
Is weak form efficient, current prices fully reflect all information contained in the historical prices of the
Asset and a trading rule based on the past prices can not be developed to identify miss-priced assets.
Market is semi-strong efficient if stock prices reflect any new publicly available information
Instantaneously. There are no undervalued or overvalued securities and thus, trading rules are
incapable
Of producing superior returns. When new information is released, it is fully incorporated into the price
rather speedily. The strong form efficiency suggests that security prices reflect all available information,
even private information. Insiders profit from trading on information not already incorporated into prices.
Hence the strong form does not hold in a world with an uneven playing field. Studies testing market
Efficiency in emerging markets is few. Poshakwale (1996) showed that Indian stock market was weak
Form inefficient; he used daily BSE index data for the period 1987 to 1994. Barua (1987), Chan, Gup
and
Pan (1997) observed that the major Asian markets were weak form inefficient. Similar results were
found
By Dickinson and Muragu (1994) for Nairobi stock market; Cheung et al (1993) for Korea and Taiwan;
and
Ho and Cheung (1994) for Asian markets. On the other hand, Barnes (1986) showed a high degree of
Efficiency in Kuala Lumpur market. Groenewold and Kang (1993) found Australian market semi-strong
form efficient. Some of the recent studies, testing the random walk hypothesis (in effect testing for weak
form efficiency in the markets) are; Korea (Ryoo and Smith, 2002; this study uses a variance ratio test
and
find the market to follow a random walk process if the price limits are relaxed during the period March
1988 to Dec 1988), China, (lee et al 2001; find that volatility is highly persistent and is predictable,
authors use GARCH and EGARCH models in this study), Hong Kong (Cheung and Coutts 2001;
authors use a
variance ratio test in this study and find that Hang Seng index on the Hong Kong stock exchange follow
a
random walk), Slovenia (Dezlan, 2000), Spain (Regulez and Zarraga, 2002), Czech Republic (Hajek,
2002),
Turkey (Buguk and Brorsen, 2003), Africa (Smith et al. 2002; Appiah-kusi and Menyah, 2003) and the
Middle East (Abraham et al. 2002; this study uses variance ratio test and the runs test to test for
random
walk for the period 1992 to 1998 and find that these markets are not efficient).
METHODOLOGY & DATA:-To test historical market efficiency one can look at the pattern of short-term
movements of the combined market returns and try to identify the principal process generating those
returns. If the market is efficient, the model would fail to identify any pattern and it can be inferred that
the returns have no pattern and follow a random walk process. In essence the assumption of random
walk
means that either the returns follow a random walk process or that the model used to identify the
process
is unable to identify the true return generating process. If a model is able to identify a pattern, then
historical market data can be used to forecast future market prices, and the market is considered not
efficient. There are a number of techniques available to determine patterns in time series data.
Regression, exponential smoothing and decomposition approaches presume that the values of the time
series being predicted are statistically independent from one period to the next. Some of these
techniques are reviewed in the following section and appropriate techniques identified for use in this
study.
Runs test (Bradley 1968) and LOMAC variance ratio test (Lo and MacKinlay 1988) are used to test the
weak
form efficiency and random walk hypothesis. Runs test determines if successive price changes are
independent. It is non-parametric and does not require the returns to be normally distributed. The test
observes the sequence of successive price changes with the same sign. The null hypothesis of
randomness
is determined by the same sign in price changes. The runs test only looks at the number of positive or
negative changes and ignores the amount of change from mean. This is one of the major weaknesses
of
the test. LOMAC variance ratio test is commonly criticised on many issues and mainly on the selection
of
maximum order of serial correlation (Faust, 1992). Durbin-Watson test (Durbin and Watson 1951), the
augmented Dickey-Fuller test (Dickey and Fuller 1979) and different variants of these are the most
commonly used tests for the random walk hypothesis in recent years (Worthington and Higgs 2003;
Kleiman, Payne and Sahu 2002; Chan, Gup and Pan 1997). Under the random walk hypothesis, a
market is
(weak form) efficient if most recent price has all available information and thus, the best forecaster of
future price is the most recent price. In the most stringent version of the efficient market hypothesis, εt
is random and stationary and also exhibits no autocorrelation, as disturbance term cannot possess any
systematic forecast errors. In this study we have used returns and not prices for test of market
efficiency
as expected returns are more commonly used in asset pricing literature (Fama (1998). Returns in a
market
conforming to random walk are serially uncorrelated, corresponding to a random walk hypothesis with
dependant but uncorrelated increments. Parametric serial correlations tests of independence and
nonparametric runs tests can be used to test for serial dependence. Serial correlation coefficient test is
a
widely used procedure that tests the relationship between returns in the current period with those in the
previous period. If no significant autocorrelation are found then the series are expected to follow a
random walk. A simple formal statistical test was introduced was Durbin and Watson (1951). Durbin-
Watson (DW) is a test for first order autocorrelation. It only tests for the relationship between an error
and its immediately preceding value. One way to motivate this test is to regress the error of time t with
its previous value.
DW test can not detect some forms of residual autocorrelations, e.g. if corr(ut, ut-1) = 0 but corr(ut, ut-
2) ≠ 0, DW as defined earlier will not find any autocorrelation. One possible way is to do it for all
possible
combinations but this is tedious and practically impossible to handle. The second-best alternative is to
test for autocorrelation that would allow examination of the relationship between ut and several of its
lagged values at the same time. The Breusch- Godfrey test is a more general test for autocorrelation for
the lags of up to r‟th order.
Because of the abovementioned weaknesses of the DW test we do not use the DW test in our study.
An
alternative model which is more commonly used is Augmented Dickey Fuller test (ADF test). Three
regression models (standard model, with drift and with drift and trend) are used in this study to test for
unit root in the research, (Chan, Gup and Pan 1997; Brooks 2002). In this study we followed the test
methodologies from Brooks (2002) with slight adjustments.
Where: St = the stock price u* and u** = the drift terms T = total number of observations εt, εt*, εt** =
error terms that could be ARMA processes with time dependent variances.
Where St is the logarithm of the price index seen at time t, u is an arbitrary drift parameter, α is the
change in the index and εt is a random disturbance term. Equation (3) is for the standard model; (4) for
the standard model with a drift and (5) for the standard model with drift and trend. Augmented Dickey-
Fuller (ADF) unit root test of nonstationarity is conducted in the form of the following regression
equation. The objective of the test is to test the null hypothesis that θ = 1 in:
against the one-sided alternative θ < 1. Thus the hypotheses to be tested are:
RESULTS:- This study conducts a test of random walk for the BSE and NSE markets in India, using
stock
market indexes for the Indian markets. It employs unit root tests (augmented Dickey-Fuller (ADF)). We
perform ADF test with intercept and no trend and with an intercept and trend. We further test the series
using the Phillips-Perron tests and the KPSS tests for a confirmatory data analysis. In case of BSE and
NSE
markets, the null hypothesis of unit root is convincingly rejected, as the test statistic is more negative
than the critical value, suggesting that these markets do not show characteristics of random walk and
as
such are not efficient in the weak form. We also test using Phillip-Perron test and KPSS test for
confirmatory data analysis and find the series to be stationary. Results are presented in Table 2. For
both
BSE and NSE markets, the results are statistically significant and the results of all the three tests are
consistent suggesting these markets are not weak form efficient.
Results of the study suggest that the markets are not weak form efficient. DW test, which is a test for
serial correlations, has been used in the past but the explanatory power of the DW can be questioned
on
the basis that the DW only looks at the serial correlations on one lags as such may not be appropriate
test
for the daily data. Current literature in the area of market efficiency uses unit root and test of
stationarity. This notion of market efficiency has an important bearing for the fund managers and
investment bankers and more specifically the investors who are seeking to diversify their portfolios
internationally. One of the criticisms of the supporters of the international diversification into emerging
markets is that the emerging markets are not efficient and as such the investor may not be able to
achieve the full potential benefits of the international diversification.
CONCLUSIONS & IMPLICATIONS: - This paper examines the weak form efficiency in two of the Indian
stock exchanges which represent the majority of the equity market in India. We employ three different
tests
ADF, PP and the KPSS tests and find similar results. The results of these tests find that these markets
are
Not weak form efficient. These results support the common notion that the equity markets in the
Emerging economies are not efficient and to some degree can also explain the less optimal allocation
of
Portfolios into these markets. Since the results of the two tests are contradictory, it is difficult to draw
Conclusions for practical implications or for policy from the study. It is important to note that the BSE
moved to a system of rolling settlement with effect from 2nd July 2006 from the previously used „Badla‟
system. The „Badla system was a complex system of forward settlement which was ‟ not transparent
and
was not accessible to many market participants. The results of the NSE are similar (NSE had a cash
settlement system from the beginning) to BSE suggesting that the changes in settlement system may
not
significantly impact the results. On the contrary a conflicting viewpoint is that the results of these
markets may have been influenced by volatility spillovers, as such the results may be significantly
different if the changes in the settlement system are incorporated in the analysis. The research in the
area of volatility spillover has argued that the volatility is transferred across markets (Brailsford, 1996),
as such the results of these markets may be interpreted cautiously. For future research, using a
computationally more efficient model like generalized autoregressive conditional heteroskesdasticity
(GARCH) could help to clear this.
Q. 3 What do you understand by yield? Explain the concept of YTM with the help of example
Meaning of Yield is the discount rate that equates the current market price of the bond with the sum of
present value of all cash flows expected from this investment.
i) Current yield: It is annual interest / current price. This calculation takes into consideration the bond
market price fluctuations and represents the present yield that a bond buyer would receive upon
purchasing a bond at given price.
a) Bond market prices move up & down with interest rate changes. If the bond is selling for a discount,
then the current yield will be greater than the coupon rate. Example : if the bond is selling for a discount
, then the current yield will be greater than the coupon rate.
ii) YTM - Yield-to Maturity : This is the investor’s total return if the bond is held to its maturity date. It
includes the annual interest payments, plus the difference between what the investor paid for the bond
and the amount of principal received at maturity
b) It is the annual rate of return that a bondholder will earn under the assumptions that the bond is held
to maturity and the interest payments are reinvested at the YTM.
c) The yield is usually quoted without making any allowance for tax paid by the investor on the return,
and is then known as "gross redemption yield". It also does not make any allowance for the dealing
costs incurred by the purchaser (or seller).
• If the yield to maturity for a bond is less than the bond's coupon rate, then the (clean) market
value of the bond is greater than the par value (and vice versa).
• If a bond's coupon rate is less than its YTM, then the bond is selling at a discount.
• If a bond's coupon rate is more than its YTM, then the bond is selling at a premium.
• If a bond's coupon rate is equal to its YTM, then the bond is selling at par
iii) Yield to call : Yield on a bond computed on the basis of assumption that its issuer will redeem it at
the first call date stated in the bond's prospectus (indenture agreement). It is a less precise and less
complex method of yield than yield to maturity.
The company has issued 10% annual coupon, 20 year bond with a face value of Rs. 1000 for Rs. 980.
i) The YTM is the annual rate of return that a bondholder will earn under the assumptions that the bond
is held to maturity and interest payments are reinvested at the YTM.
Master of Business Administration- MBA Semester 3
MF0001 – Security Analysis and Portfolio Management - 2 Credits
BKID: B1035
Assignment Set- 2 (30 Marks)
Note: Each question carries 10 Marks. Answer all the questions.
Q.1 With the help of examples explain what is systematic (also called systemic) and unsystematic risk?
All said and done CAPM is not perfect, do you agree?
Ans: Systematic risk: In finance, systematic risk, sometimes called market risk, aggregate risk, or
Un diversifiable risk, is the risk associated with aggregate market returns.
Systematic risk should not be confused with systemic risk, the risk of loss from some catastrophic event
that collapses the entire financial system.
It is the risk which is due to the factors which are beyond the control of the people working in the market
and that's why risk free rate of return in used to just compensate this type of risk in market. Interest
rates, recession and wars all represent sources of systematic risk because they affect the entire market
and cannot be avoided through diversification. Whereas this type of risk affects a broad range of
securities, unsystematic risk affects a very specific group of securities or an
individual security. Systematic risk can be mitigated only by being hedged. Even a portfolio of well
diversified assets cannot escape all risk.
Example
Examples of systematic risk include uncertainty about general economic conditions, such as GNP,
interest
rates or inflation.
For example, consider an individual investor who purchases $10,000 of stock in 10 biotechnology
companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices
drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single
biotechnology company would incur ten times the loss from such an event. The second investor's
portfolio
has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect the entire
industry instead, the investors would incur similar losses, due to systematic risk.
Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest rates and
so
on. It may also derive from the structure and dynamics of the market.
Unsystematic risk
By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or
diversifiable risk, is the company-specific or industry-specific risk in a portfolio, which is uncorrelated
with aggregate market returns.
Unsystematic risk can be mitigated through diversification, and systematic risk can not be.
This is the risk other than systematic risk and which is due to the factors which are controllable by the
people working in market and market risk premium is used to compensate this type of risk.
Total Risk = Systematic risk + Unsystematic Risk
The risk that is specific to an industry or firm. Examples of unsystematic risk include losses caused by
labor problems, nationalization of assets, or weather conditions. This type of risk can be reduced by
assembling a portfolio with significant diversification so that a single event affects only a limited number
of the assets.
Company- or industry-specific risk as opposed to overall market risk; unsystematic risk can be reduced
through diversification. As the saying goes, “Don't put all of your eggs in one basket.” Also known as
specific risk, diversifiable risk, and residual risk.
Example
On the other hand, announcements specific to a company, such as a gold mining company striking
gold,
are examples of unsystematic risk.
The model assumes that the variance of returns is an adequate measurement of risk. This might
be justified under the assumption of normally distributed returns, but for general return
distributions other risk measures (like coherent risk measures) will likely reflect the investors'
preferences more adequately. Indeed risk in financial investments is not variance in itself, rather
it is the probability of losing: it is asymmetric in nature.
The
model assumes that all investors have access to the same information and agree about the
risk and expected return of all assets (homogeneous expectations assumption).
The
model assumes that the probability beliefs of investors match the true distribution of returns.
A different possibility is that investors' expectations are biased, causing market prices to be
informationally inefficient. This possibility is studied in the field of behavioral finance, which uses
psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based
asset pricing model of Kent Daniel, David Hirshleifer, and AvanidharSubrahmanyam (2001).
The
model does not appear to adequately explain the variation in stock returns. Empirical studies
show that low beta stocks may offer higher returns than the model would predict. Some data to
this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer
Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the
efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but
makes the EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably
beating the market).
The
model assumes that given a certain expected return investors will prefer lower risk (lower
variance) to higher risk and conversely given a certain level of risk will prefer higher returns to
lower ones. It does not allow for investors who will accept lower returns for higher risk. Casino
gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.
The
model assumes that there are no taxes or transaction costs, although this assumption may be
relaxed with more complicated versions of the model.
The
market portfolio consists of all assets in all markets, where each asset is weighted by its
market capitalization. This assumes no preference between markets and assets for individual
investors, and that investors choose assets solely as a function of their risk-return profile. It also
assumes that all assets are infinitely divisible as to the amount which may be held or transacted.
The
market portfolio should in theory include all types of assets that are held by anyone as an
investment (including works of art, real estate, human capital...) In practice, such a market
portfolio is unobservable and people usually substitute a stock index as a proxy for the true
market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can
lead to false inferences as to the validity of the CAPM, and it has been said that due to the
inobservability of the true market portfolio, the CAPM might not be empirically testable. This was
presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's
critique.
The
model assumes just two dates, so that there is no opportunity to consume and rebalance
portfolios repeatedly over time. The basic insights of the model are extended and generalized in
the intertemporal CAPM (ICAPM) of Robert Merton, and the consumption CAPM (CCAPM) of Douglas
Breeden and Mark Rubinstein.
CAPM
assumes that all investors will consider all of their assets and optimize one portfolio. This is
in sharp contradiction with portfolios that are held by individual investors: humans tend to have
fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio.
Q. 2 What do you understand by arbitrage? Make a critical comparison between APT & CAPM.
Ans: In economics and finance, arbitrage is the practice of taking advantage of a price difference
between two or more markets: striking a combination of matching deals that capitalize upon the
imbalance, the profit being the difference between the market prices. When used by academics, an
arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a
positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit at zero
cost.
In principle and in academic use, an arbitrage is risk-free; in common use, as in statistical arbitrage, it
may refer to expected profit, though losses may occur, and in practice, there are always risks in
arbitrage, some minor (such as fluctuation of prices decreasing profit margins), some major (such as
devaluation of a currency or derivative). In academic use, an arbitrage involves taking advantage of
differences in price of a single asset or identical cash-flows; in common use, it is also used to refer to
differences between similar assets (relative value or convergence trades), as in merger arbitrage.
People who engage in arbitrage are called arbitrageurs—such as a bank or brokerage firm. The term is
mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and
currencies.
Examples
Suppose
that the exchange rates (after taking out the fees for making the exchange) in London are
£5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = $12 = £6. Converting ¥1000 to $12
in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In
reality, this "triangle arbitrage" is so simple that it almost never occurs. But more complicated
foreign exchange arbitrages, such as the spot-forward arbitrage (see interest rate parity) are
much more common.
One
example of arbitrage involves the New York Stock Exchange and the Chicago Mercantile
Exchange. When the price of a stock on the NYSE and its corresponding futures contract on the
CME are out of sync, one can buy the less expensive one and sell it to the more expensive market.
Because the differences between the prices are likely to be small (and not to last very long), this
can only be done profitably with computers examining a large number of prices and automatically
exercising a trade when the prices are far enough out of balance. The activity of other
arbitrageurs can make this risky. Those with the fastest computers and the most expertise take
advantage of series of small differences that would not be profitable if taken individually.
Economists
use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to
flow towards whichever country has the lowest wages per unit output at present and has reached
the minimum requisite level of political and economic development to support industrialization.
At present, many such jobs appear to be flowing towards China, though some which require
command of English are going to India and the Philippines. In popular terms, this is referred to as
offshoring. (Note that "offshoring" is not synonymous with "outsourcing", which means "to
subcontract from an outside supplier or source", such as when a business outsources its
bookkeeping to an accounting firm. Unlike offshoring, outsourcing always involves subcontracting
jobs to a different company, and that company can be in the same country as the outsourcing
company.)
Sports
arbitrage – numerous internet bookmakers offer odds on the outcome of the same event.
Any given bookmaker will weight their odds so that no one customer can cover all outcomes at a
profit against their books. However, in order to remain competitive their margins are usually quite
low. Different bookmakers may offer different odds on the same outcome of a given event; by
taking the best odds offered by each bookmaker, a customer can under some circumstances cover
all possible outcomes of the event and lock a small risk-free profit, known as a Dutch book. This
profit would typically be between 1% and 5% but can be much higher. One problem with sports
arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the
'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering
or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb'
usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one
side of the market also alert the bookies to correct the market.
Exchange-traded
fund arbitrage – Exchange Traded Funds allow authorized participants to
exchange back and forth between shares in underlying securities held by the fund and shares in
the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the
fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may
trade at a premium or discount to the value of the underlying assets. When a significant enough
premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the
ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the
reverse. In this way, the arbitrageur makes a low-risk profit, while fulfilling a useful function in
the ETF marketplace by keeping ETF prices in line with their underlying value.
Some
types of hedge funds make use of a modified form of arbitrage to profit. Rather than
exploiting price differences between identical assets, they will purchase and sell securities, assets
and derivatives with similar characteristics, and hedge any significant differences between the
two assets. Any difference between the hedged positions represents any remaining risk (such as
basis risk) plus profit; the belief is that there remains some difference which, even after hedging
most risk, represents pure profit. For example, a fund may see that there is a substantial
difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a
series of matching trades (including currency swaps) to arbitrage the difference, while
simultaneously entering into credit default swaps to protect against country risk and other types
of specific risk.
APT
applies to well diversified portfolios and not necessarily to individual stocks.
With
APT it is possible for some individual stocks to be mispriced - not lie on the SML.
APT
is more general in that it gets to an expected return and beta relationship without the
assumption of the market portfolio.
APT
can be extended to multifactor models.
Both
the CAPM and APT are risk-based models. There are alternatives.
Empirical
methods are based less on theory and more on looking for some regularities in the
historical record.
Be
aware that correlation does not imply causality.
Related
to empirical methods is the practice of classifying portfolios by style e.g.
o Value portfolio
o Growth portfolio
The
APT assumes that stock returns are generated according to factor models such as:
As
securities are added to the portfolio, the unsystematic risks of the individual securities offset
each other. A fully diversified portfolio has no unsystematic risk.
The
CAPM can be viewed as a special case of the APT.
Empirical
models try to capture the relations between returns and stock attributes that can be
measured directly from the data without appeal to theory.
Difference
in Methodology
CAPM is an equilibrium model and derived from individual portfolio optimization.
APT is a statistical model which tries to capture sources of systematic risk. Relation between
sources determined by no Arbitrage condition.
Difference
in Application
APT difficult to identify appropriate factors.
CAPM difficult to find good proxy for market returns.
APT shows sensitivity to different sources. Important for hedging in portfolio formation.
CAPM is simpler to communicate, since everybody agrees upon
Ans : Arbitrage pricing theory (APT), in finance, is a general theory of asset pricing, that has become
influential in the pricing of stocks.
APT holds that the expected return of a financial asset can be modeled as a linear function of various
macro-economic factors or theoretical market indices, 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.
Risky asset returns are said to follow a factor structure if they can be expressed as:
where
E(rj) is the jth asset's expected return,
bjk is the sensitivity of the jth asset to factor k, also called factor loading,
andεj is the risky asset's idiosyncratic random shock with mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.
RR
βI FI βGDP FGDP βS FS ε
The APT states that if asset returns follow a factor structure then the following relation exists between
expected returns and the factor sensitivities:
where
2. they should represent undiversifiable influences (these are, clearly, more likely to be
macroeconomic rather than firm-specific in nature)