(Arbitrage pricing theory)

INTRODUCTION TO CAPITAL MARKETS

A market where debt or equity securities are traded. The market for trading long-term debt instruments (those that mature in more than one

year). Capital markets include the stock and bond markets.

Companies and governments use capital markets to raise funds for their operations. Investors purchase securities in the capital markets in order to extract a return and earn

profit on the securities.

Capital markets include primary markets and secondary markets in which all subsequent

trading takes place.

The means by which large amounts of money (capital) are raised by companies,

governments and other organizations for long term use and the subsequent trade of the instruments issued in recognition of such capital.

INTRODUCTION TO ARBITRAGE THEORY

WHAT IS ARBITRAGE ?
WHAT IS ARBITRAGE PRICING THEORY? WHY DO WE NEED ARBITRAGE PRICING THEORY?

ARBITRAGE PRICING THEORY

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.

ASSUMPTIONS OF APT
Capital markets are perfectly competitive

Investors always prefer more wealth to less

wealth with certainty. The return on an asset is influenced by a variety of factors contrary to single factor in CAPM. But the APT does not specify these factors clearly. The relation between factors and return is linear.

CONCEPT OF ARBITRAGE PRICING THEORY

Multiple factors expected to have an impact on all assets: Inflation GNP Major political upheavals Changes in interest rates, etc. Above factors affect individual firms differently. All affecting factors should be considered collectively for every firm individually

E(Rj)=Rf+(1f1+2f2+3f3+.+nfn)+URs Where E(Rj)=Return on Asset Rf=Expected Return URs=Unexpected Return =Beta for particular factor f=Factor

ADVANTAGES OF APT
Less restrictive assumptions about investors

preferences towards risk and premium. No assumptions made about distribution of Security returns. APT does not rely on identification of true market portfolio, the theory is potentially testable.

LIMITATIONS OF APT
Arbitrage pricing theory does not rely on measuring the performance of the market. Instead, APT directly relates the price of the security to the fundamental factors driving it. The problem with this is that the theory in itself provides no indication of what these factors are, so they need to be empirically determined. Obvious factors include economic growth and interest rates. For companies in some sectors other factors are obviously relevant as well - such as consumer spending for retailers. The potentially large number of factors means more betas to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM.

APT versus CAPM

APT is a more general approach to asset pricing than CAPM. CAPM considers variances and covariance's as possible

measures of risk while APT allows for a number of risk factors.

APT shows that a securitys expected return is influenced by a

variety of factors, as opposed to just the single market index of CAPM

APT in contrast states that return on a security is linearly

related to factors.
APT does not specify what factors are, but assumes that the

relationship between security returns and factors is linear.

CONCLUSION
APT is a result of CAPM limitations.
APT is a multi factor model to explain the

risk and return of a security. APT is widely used in the stock market of today. It helps to establish the price model for various shares.

PRESENTED BY PALIKUMARI POOJA DAFTARI

SNEHAL NAVGIRE
ANANTDEEP DIVYA KHATRI

THANK YOU