Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT)

like the CAPM, APT is an equilibrium model as to how security prices are determined this theory is based on the idea that in competitive markets, arbitrage will ensure that riskless assets provide the same expected return 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 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 and CAPM

APT allows the individual investor more freedom to develop a model

that explains the expected return for a particular asset The expected return on an asset is a function of many factors as well as the sensitivity of the stock to these factors" while 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 stock market 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.

The APT Formula:

E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn

where: E(rj) = the asset's expected rate of return rf = the risk-free rate bj = the sensitivity of the asset's return to the particular factor RP = the risk premium associated with the particular factor

APT Factor Models Approach

Two-factor Model (actual return on a security)

Rj = a + b1jF1 + b2jF2 + ej
where: a= the return when all factors have zero values fn = the value (uncertain) of factor n

bnj = the reaction coefficient depicting the change in the security's return to a one-unit change in the factor
ej = the error term

Leeny Kelly Company's stock is related to the following factors with respect to actual return:

Rj = a + .8(F1)+ 1.2(F2) + .3(F3) + ej

Suppose that the a term for the stock is 14 percent and that for the period the unanticipated change in factor 1 is 5 percent, factor 2 is 2 percent, and factor 3 is 10 percent. If the error term is zero, what would be the stock's actual return for the period?

Rj

= a + .8(F1)+ 1.2(F2) + .3(F3) + ej = .14 + .8(.05) + 1.2(.02) + .3(.10) + 0 = 3.24%

APT Factor Models Approach

Two-factor Model (expected return on a security)

()j = 0 + 1b1j + 2b2j

where: 0 = corresponds to the return on a risk-free asset 1 = the expected excess return (above the risk-free rate) when: b1j = 1 and b2j = 0

Suppose Torquay Resorts Limited's stock is related to two factors where the reaction coefficients, b1j and b2j are 1.4 and .8, respectively. If the risk-free rate is 8 percent, and 1 is 6 percent and 2 is 2 percent, the stock's expected return is:

()j = 0 + 1b1j + 2b2j ()j = .08 + .06(1.4) - .02(.8) = 14.8%

The first factor reflects risk aversion and must be compensated for with a higher expected return, whereas the second is a thing of value to investors and lowers the return they expect. Thus, the 's represent market prices associated with factor risks.

APT Factor Models Approach

More than two factors Model (expected return)

()j = A + 1 b1j + 2b2j + + nbnj

where: 1 = represents the expected return in excess of the risk-free rate when the reaction coefficient for the first factor, b1j = is 1.0

Suppose returns required in the market by investors are a function of two factors according to the following equation, where the riskfree rate is 7 percent. Quigley Manufacturing Company and Zolotny Basic Products Corporation both have the same reaction coefficients to the factors, such that b1j = 1.3 and b2j = .9

()j = A + 1 b1j + 2b2j + + nbnj

()j = .07 + .04(b1j) - .01(b2j) = .07 + .04(1.3) - .01(9) = 11.3%

Roll-Ross Five Factors

1. changes in expected inflation 2. unanticipated changes in inflation 3. Unanticipated changes in industrial production 4. unanticipated changes in the yield differential between low and high-grade bonds (the default-risk premium) 5. unanticipated changes in the yield differential between longterm and short-term bonds (the term structure of interest rates)

 Roll-Ross may be expressed as: ()j = 0 + 1(b1jEA inflation) + 2(b2jUA inflation) + 3 (b3jUA industrial production) + 4 (b4jUA bond risk premium) + 5 (b5jUA long minus short rate) where: EA = is an expected change UA = represents an unanticipated change

()j

= 0 + 1(b1jEA inflation) + 2(b2jUA inflation) + 3 (b3jUA industrial production) + 4 (b4jUA bond risk premium) + 5 (b5jUA long minus short rate) = .00412 - .00013(b1jEA inflation) - .00063(b2jUA inflation) + .01359(b3jUA industrial production) + .00721(b4jUA bond risk premium) - .00521(b5jUA long minus short rate)

()j

Suppose the b's for CRR Corporation are: b1= 1.8 b2 = 2.4 b3 = .9 b4= .5 b5= 1.1 Under these conditions, the expected return for the stock is ()crr = .00412 - .00013(1.8) - .00063(2.4) + .01359(.9) + .00721(.5) - .00521(1.1) = 1.25%