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As its name implies, the Arbitrage Pricing Theory, or APT, describes a mechanism used by investors to identify an asset, such as a share of common stock, which is incorrectly priced. Investors can subsequently bring the price of the security back into alignment with its actual value.
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rf = the risk free interest rate, which is the interest rate the investor would expect to receive from a risk-free investment. Typically, U.S. Treasury Bills are used for U.S. dollar calculations, while German Government bills are used for the Euro b = the sensitivity of the stock or security to each factor factor = the risk premium associated with each factor
Stock Research Part I Calculating Stock Prices Capital Asset Pricing Model Arbitrage Pricing Theory Stock Beta and Volatility Reading a Value Line Report Understanding Price Momentum
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. Arbitrage is the term used to describe how investors could go about getting this formula, or equation, back into balance.
Each of the factors affecting a particular stock The expected returns for each of these factors The sensitivity of the stock to each of these factors
Identifying and quantifying each of these factors is no trivial matter, and is one of the reasons the Capital Asset Pricing Model remains the dominant theory to describe the relationship between a stock's risk and return. Keeping in mind that the number and sensitivities of a stock to each of these factors is likely to change over time, Ross and others identified the following macro-economic factors they felt played a significant role in explaining the return on a stock:
Inflation GNP or Gross National Product Investor Confidence Shifts in the Yield Curve
With that as guidance, the rest of the work is left to the stock analyst.
sensitivity of the stock to these factors." As these factors move, so does the expected return on the stock, and therefore its value to the investor. 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. The CAPM is really just a simplified version of the APT, whereby the only factor considered is the risk of a particular stock relative to the rest of the stock market, as described by the stock's beta. 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.