What is Arbitrage Pricing Theory | Arbitrage Pricing Theory (5 Points to know)

To put arbitrage pricing theory(APT) in simple terms it is based on a multi factor model where beta values are assigned individually to each factor. Although this is slightly complex to understand. Let’s take a look at this finance concept in this article.

Definition

It states that there is a set of individual macro economic factors along with the risk premium associated with those factors which determine the return of an investment.

Arbitrage Pricing Theory Formula

Arbitrage Pricing Theory Assumptions

• It assumes that there are no arbitrage opportunities in the market.
• Investors can trade assets at any time.
• Investors have same amount of resources to access information.
• Investors are risk averse and efficient.

Arbitrage Pricing Theory Example

A stock’s return is based on following risk factors –

Calculate the expected return based on APT.

Solution –

Expected Return (R_e) = R_f + [{(β_n) * (λ_n)} + {(β_g) * (λ_g)} + {(β_d) * (λ_d)} + {(β_i) * (λ_i)}]

Expected Return (R_e) = (5%) + [{(0.4) * (10%)} + {(0.7) * (4%)} + {(1.2) * (7%)} + {(0.9) * (4.5%)}]

Expected Return (R_e) = (5%) + [(0.04) + (0.028) + (0.084) + (0.0405)

Expected Return (R_e) = 24.25 %

Arbitrage Pricing Theory vs Capital Asset Pricing Model

CAPM takes in to account single beta value while Arbitrary Pricing Model takes into account multiple beta values for ascertaining expected return of an investment. Hence we can say that the simplest form of Arbitrage Pricing Theory i.e. Model having only one beta factor is consistent with CAPM.

• Macroeconomic factors are taken into consideration which provides a more holistic view.
• Lack of consistency in quantifying of APT model because it is difficult to establish the relationship among each other for factors.
• The expected return in APT is closer to reality than in CAPM
• No well defined market portfolio like CAPM.

Risk Factors

The risks associated with APT cannot be reduced merely by market diversification. Risks factor included are systematic risks i.e. they are the kind of risks that are inherent to the whole market. These risks include –

1. Market Risk
2. Interest Rate Risk
3. Inflation Risk
4. Natural Calamity Risk
5. Geopolitical Risk

Arbitrage Pricing Theory Advantages and Disadvantages

Advantages

• More accurate estimation of required rate of return than CAPM.
• Takes systematic risks into account.

Disadvantages

• Factors are not well specified.
• Difficult to establish relationship among factors.

Real world application of arbitrage pricing theory

1. Making factor bets. E.g – If investor thinks that interest rate risk would be 8% while market expects it to be 6% then investor can increase his return by acting positively on the side of inflation.
2. Identification of under-priced or over-priced securities.
3. Used to estimate required rate of return
4. Can be used in arbitrage cases.

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FAQs

FAQs of Arbitrage Pricing Theory

Read More –

CAPM Capital Asset Pricing Model Concept, Assumptions, Formula

Profitability Index Definition, Formula, Example, Calculation

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