Arbitrage pricing theory

The theory aims to pinpoint the fair market price of a security Arbitrage pricing theory may be temporarily mispriced. This relationship takes the form of the linear regression formula above.

The theory provides investors and analysts with the Arbitrage pricing theory to customize their research. Unlike the Capital Asset Pricing Model CAPM which only takes into account the single factor of the risk level of the overall market, the APT model looks at several macroeconomic factors that, according to the theory, determine the risk and return of the specific asset.

When the investor is long the asset and short the portfolio or vice versa he has created a position which has a positive expected return the difference between asset return and portfolio return and which has a net-zero exposure to any macroeconomic factor and is therefore risk free other than for firm specific risk.

For example, if a portfolio has a beta of 1. After all, a portfolio can have Arbitrage pricing theory and sensitivities to certain kinds of risk factors as well. Factors[ edit ] As with the CAPM, the factor-specific betas are found via a linear regression of historical security returns on the factor in question.

The theory assumes that market action is less than always perfectly efficient, and therefore occasionally results in assets being mispriced — either overvalued or undervalued — for a brief period of time. Other commonly used factors are gross domestic product GDPcommodities prices, market indices and exchange rates.

Arbitrage pricing theory

The arbitrageur creates the portfolio by identifying x correctly priced assets one per factor plus one and then weighting the assets such that portfolio beta per factor is the same as for the mispriced asset. To learn more about evaluating securities in regard to risk vs. Some other commonly used factors in the APT are GDP, commodities prices, market indices levels, and currency exchange rates.

Although a bit complex to work with, and something that requires time and practice to become adept at using, the Arbitrage Pricing Theory is an analytical tool that investors can use to evaluate their portfolio holdings from a basic value investing perspective, looking to identify securities that may be temporarily mispriced, well below or above their fair market value.

Market indices are sometimes derived by means of factor analysis. To an arbitrageur, temporarily mispriced securities represent a short-term opportunity to profit virtually risk-free.

Since the CAPM is a one-factor model and simpler to use, investors may want to use it to determine the expected theoretical appropriate rate of return rather than using APT, which requires users to quantify multiple factors. Gross domestic product growth: Stephen Ross developed the theory in At the end of the period: Relationship with the capital asset pricing model[ edit ] The APT along with the capital asset pricing model CAPM is one of two influential theories on asset pricing.

A correctly priced asset here may be in fact a synthetic asset - a portfolio consisting of other correctly priced assets.

This portfolio has the same exposure to each of the macroeconomic factors as the mispriced asset. These factors provide risk premiums for investors to consider because the factors carry the systematic risk that cannot be eliminated by diversification of an investment portfolio.

Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies.

In general, historical securities returns are regressed on the factor to estimate its beta. Several a priori guidelines as to the characteristics required of potential factors are, however, suggested: However, it is more difficult to apply, as it takes a considerable amount of time to determine all the various risk factors that may influence the price of an asset.

It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio".

Arbitrage Pricing Theory (APT)

The macroeconomic factors that have proven most reliable as price predictors include unexpected changes in inflation, gross national product GNPcorporate bond spreads and shifts in the yield curve.

Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: What the arbitrage pricing theory offers traders is a model for determining the theoretical fair market value of an asset.

And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks. The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at more than this rate.

Arbitrage[ edit ] Arbitrage is the practice of taking positive expected return from overvalued or undervalued securities in the inefficient market without any incremental risk and zero additional investments.

As a practical matter, indices or spot or futures market prices may be used in place of macro-economic factors, which are reported at low frequency e.

Which factors, and how many of them are used, are subjective choices — which means investors will have varying results depending on their choice. Ross developed the APT on a basis that the prices of securities are driven by multiple factors, which could be grouped into macroeconomic or company-specific factors.

Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model. However, market action should eventually correct the situation, moving price back to its fair market value.

The implication is that at the end of the period the portfolio would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at less than this rate.

It is up to the analyst to decide which influences are relevant to the asset being analyzed. On the other side, the capital asset pricing model is considered a "demand side" model.In the s, Jack Treynor, William F.

Sharpe, John Lintner and Jan Mossin developed the capital asset pricing model (CAPM) to determine the theoretical appropriate rate that an asset should.

In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.

CAPM vs. Arbitrage Pricing Theory: How They Differ

Arbitrage pricing theory is an asset pricing model that predicts a security's return using the linear relationship between its expected return and macroeconomic factors.

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns can be forecast using the linear relationship between the asset’s expected return and a number of macroeconomic factors that affect the asset's risk.

This theory was created in by the economist, Stephen Ross. Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset.

Arbitrage Pricing Theory

The theory assumes an asset's return is dependent on various macroeconomic, market and security-specific factors. ARBITRAGE PRICING THEORY∗ Gur Huberman Zhenyu Wang† August 15, Abstract Focusing on asset returns governed by a factor structure, the APT is .

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Arbitrage pricing theory
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