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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.
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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.
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.
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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