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APT

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Arbitrage pricing theory is one of the tools used by the investors and

portfolio manager. The capital asset pricing theory explains the return of the

securities on the basis of their respective betas. According to the previous

models, the investor chooses the investment on the basis of expected return

and variance. The alternative model developed in asset pricing by Stephen

Ross is known as Arbitrage Pricing Theory. The APT theory explains the

nature of equilibrium in the asset pricing in a less complicated manner with

fewer assumptions compared to CAPM.

Arbitrage

Arbitrage is a process of earning profit by taking advantage of differential

pricing for the same asset. The process generates riskless profit. In the

security market, it is of selling security at a higher price and the

simultaneous purchase of the same security at a relatively lower price. Since

the profit earned through arbitrage is riskless, the investors have the

incentive to undertake this whenever an opportunity arises. In general, some

investors indulge more in this type of activities than other. However, the

buying and selling activities of the arbitrageur reduce and eliminate the

profit margin, bringing the market price to the equilibrium level.

The Assumptions

1. The investors have homogeneous expectations.

2. The investors are risk averse and utility maximisers.

3. Perfect completion prevails in the market and there is no transaction

cost.

1

The APT theory does not assume (1) single period investment horizon, (2)

no taxes, (3) investors can borrow and lend at risk free rate of interest and

(4) the selection of the portfolio is based on the mean and variance analysis.

These assumptions are present in the CAPM theory.

Arbitrage Portfolio

According to the APT theory an investor tries to find out the possibility to

increase returns from his portfolio without increasing the funds in the

portfolio. He also likes to keep risk at the same level. For example, the

investor holds, A, B and C securities and he wants to change the proportion

of the securities without any additional financial commitment. Now the

change in proportion of securities can be denoted by XA, XB and XC. The

increase in the investment in security A could be carried out only if he

reduces the proportion of investment either in B or C because it has already

stated that investor tries to earn more income without increasing his

financial commitment. Thus, the changes in different securities will add up

to zero. This is the basic requirement of an arbitrage portfolio. If X indicates

change in proportion,

X A + XB + XC = 0

The factor sensitivity indicates the responsiveness of a securitys return to a

particular factor. The sensitiveness of the securities to any factor is the

weighted average of the sensitivities of the securities, in an arbitrage

portfolio the sensitivities become zero.

bA XA + bB XB + bC XC = 0

the investor holds the A, B and C stocks with the following returns and

sensitivity to changes in the industry production. The total amount invested

is Rs.1, 50,000.

1

Stock A

Stock B

Stock C

R

20%

15%

12%

b

.45

1.35

.55

Original weights

.33

.33

.34

The changes are

XA = .2

XB = .025

XC = -.225

XA + XB + Xc 0

The variance of the new portfolios change is only due to the changes in its

non-factor risk. Hence, the change in the risk factor is negligible. From the

analysis it can be concluded that

1. The return in the arbitrage portfolio is higher than the old portfolio.

2. The arbitrage and old portfolio sensitivity remains the same.

3. The non-factor risk is small enough to be ignored in an arbitrage

portfolio.

EFFECT ON PRICE: to buy stock A and B the investors has to sell

stock C. the buying pressure on stock A and B would lead to increase in

their prices. Conversely selling of stock C will result in fall in the price

of the stock C. with the low price thre would be rise in the expected

return on stock C. for example, if the stock C at price Rs100 per

3

would be 12/80 * 100=15%. At the same time, return rates would be

declining in stock A and B with the rise in price. This buying and selling

activity will continue until all arbitrage possibilities are eliminated. At

this juncture, there exists an approximate linear relationship between

expected returns and sensitivities.

securities are influenced by a number of macro economic factors. The

macro economic factors are growth rate of industrial production, rate

of inflation, spread between long term and short term interest rates

and spread between low-grade and high grade bonds.

The arbitrage theory is represented by theory:

Ri = 0 + 1 bi1 + 2 bi2 + j bij

Ri = average expected return

1 = sensitivity of return to bi1

bi1 = the beta co-efficient relevant to the particular factor

The equation is derived from the model

Ri = 1 + bi1 I1 + bi2 I2 . + bij Ij + ei

Let us take the two factor model

Ri = 0 + 1 bi2 + bi2

If the portfolio is well diversified one, unsystematic risk tends to be

zero and systematic risk is represented by bi1 and bi2 in the equation.

Let us assume the existence of three well diversified portfolios as

shown in the table.

Portfolio

A

B

C

Expected return

12.0

13.4

12

bi2

1

3

3

bi2

0.5

0.2

-0.5

the above mentioned details. By solving the following equations

12 = 0 + 11 + 0.52

13.4 = 0 + 31 + 0.22

12 = 0 + 31 0.52

We can get

Ri = 10 = 1bi1 = 2 bi2

The expected return is

Rp =

i=1

Xi Ri

All the portfolios constructed from portfolios A, B and C lie on the plane

described A, B and C. Assume there exists a portfolio D with an

expected return 14%, bi1 = 2.3 and bi2 = .066. This portfolio can be

compared with the portfolio E having equal portion of A, B and C

portfolios. Every portfolio would have a share of 33%. The portfolio b pj

are

bp1 = 1/3 * 1 +1/3 *3 + 1/3 * 3 = 2.33

bp2 = .5 * 1/3 + .2 1/3 + (-.5 *1/3) = .066

The risk for portfolio E is identical to the risk on portfolio D. the

expected return for portfolio E is

1/3 (12) 1/3 (13.4) + 1/3 (12)

=12.46

Since the portfolio E lies on the plane described above, the return

could be obtained from the equation of the plane.

5

R = 10 + 1(2.33) + 2 (.066)

=12.46

The portfolio D and E have the same risk but different returns. In this

juncture, the arbitrageur enters in and buy portfolio D by selling

portfolio E short. Thus buying of portfolio D through the funds

generated from selling E would provide riskless profit with no

investment and no risk. Let us assume that the investor sells Rs 1000

worth of potfolio E and buys Rs 1000 worth of portfolio D. the cash flow

is as shown in the following table.

Portfolio D

Portfolio E

Arbitrage

Portfolio

Initial cash

flow

-Rs 1000

+Rs 1000

0

End of

period

+ 1140.0

- 1124.6

15.4

bi1

Bi2

+2.33

-2.33

0

+.06

-.06

0

(bi1 and bi2) and earns Rs 15.4. Arbitrage would continue until

portfolio D lies on the same plane.

ARBITRAGE PRICING EQUATION

In a single factor model, the linear relationship between the return Ri

and sensitivity bi can be given in the following form.

R i = 0 + i b i

Ri = return from stock A

0 = riskless rate of return

i = slope of the arbitrage pricing line

bi = the sensitivity related to the factor

The above model is known as single factor model since only one

factore is considered. Hence, the industrial production alone is

considered. The APT one factore model is given in following figure:

The risk is measured along the horizontal axis and the return on the

vertical axis. The A, B and C stocks are considered to be in the same

risk class. The arbitrage pricing line intersects the Y axis on 0, which

represents riskless rate of interest i.e. the interest offered for the

treasury bills. Here, the investments involve zero risk and it is

appealing to the investors who are highly risk averse. i stands for the

slope of arbitrage pricing line. It indicates market price of risk and

measures the risk-return trade off in the security markets. The i is the

sensitivity coefficient or factor beta that shows the sensitivity of the

asset or stock A to there respective risk factor.

THE CONSTANTS OF THE APT EQUATION

The existence of the risk free asset yields a risk free rate of return that

is a constant. The asset does not have sensitivity to the factor for

example, the industrial production.

If bi = 0

Ri = 0 + i0

R i = 0

R i = 0

In other words, 0 is equal to the risk free rate of return. If the single

factor portfolios sensitivity is equal to one i.e. bi = 1 then

Ri = 0 + i1

This can be rewritten as

R i = 0 + i

Ri - 0 = i

Thus, i is the expected excess return over the risk free rate of return

for a portfolio with unit sensitivity to the factor. The excess return is

known as risk premium.

FACTORS AFFECTING THE RETURN

The specification of the factors is carried out by many financial

analysts. Chen, Roll and Ross have taken four macro economic

variables and tested them. According to them the factors are inflation,

the term structure of interest rates, risk premia and industrial

production. Inflation affects the discount rate or the required rate of

return and the size of the future cash flows. The short term inflation is

measured by monthly percentage changes in the consumer price

index. The interest rates on long term payments. The difference

between the return on the high grade bonds and low grade (more

risky) bonds indicates the markets reaction to risk. The industrial

production represents the business cycle changes in the industrial

production have an impact on the expectations and opportunities of

the investor the real value of the cash flow is also affected by it.

some other factors. they are given below.

Default risk

Time premium

Deflation

Change in expected sales

The markers return not due to the first four variables.

The default risk is measured by the difference between the return on long

term government bonds and the return on long term bonds issued by

corporate plus one-half of one per cent. Time premium is measured by return

on long term government bonds minus one month Treasury bill rate one

month ahead. Deflation is measured by expected inflation at the beginning

of the month minus actual inflation during the month. According to them, the

first four factors accounted 25% of the variation in the Standard and Poor

Composite index and all the four co-efficients were significant.

Salomon Brothers identified five factors in their fundamental factor model.

Inflation is the only common factor identified by others. The other factors are

given below.

8

Rate of interest

Rate of change in all prices

Rate of change in defence spending

All the three sets of factors have some common characteristics. They all

affect the macro economic activities. Inflation and interest rate are identified

as common factors. Thus, the stock price is related to aggregate economic

activity and the discount rate of future cash flow.

The simplest form of APT model is consistent with the simple from of

the CAPM model. When only one factor is taken into consideration, the

APT can be stated as:

R i = 0 + b i i

It is similar to the capital market line equation

Ri = Rf + i (Rm Rf)

This is similar to the CAPM model.

APT model is more general and less restrictive than CAPM. In APT, the

investor has no need to hold the market portfolio because it does not make

use of the market portfolio concept. The portfolios are constructed on the

basis of the factors to eliminate arbitrage profits. APT is based on the law of

one price to hold for all possible portfolio combinations.

The APT model takes into account of the impact of numerous factors on the

security. The macro economic factors are taken into consideration and it is

closer to reality than CAPM.

The market portfolio is well defined conceptually. In APT model, factors are

not well specified. Hence the investors fund it difficult to establish equilibrium

relationship. The well defined market portfolio is a significant advantage of

the CAPM leading to the wide usage of the model in the stock market.

The factors that have impact on one group of securities may not affect

another group of securities. There is lack of consistency in the measurement

of the APT model.

Further, the influences of the factors are not independent of each other. If

may be difficult to identify the influence that correspond exactly to each

factor. Apart from this not all variables that exert influence on a factor are

measurable.

APT

Investor do not look at expected

returns and standard deviations

Risk return analysis is not a basis

Investors prefer higher wealth/returns

to lower wealth

APT is based on the return generated

by factor model.

CAPM

Investors look at the expected returns

and accompanying risks measured by

standard deviation

Investors are risk averse and risk

return analysis is necessary

Investors maximize wealth for a given

level of risk

CONCLUSION

an arbitrage portfolio is constructed without any additional financial

commitment

investors indulge in arbitrage, moving the price upwards if securities

are held long and driving down the price of securities if held in short

position, till the elimination of the arbitrage possibilities

The factor sensitivity in arbitrage model indicates the responsiveness

of a securitys return to a particular factor.

10

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