Arbitrage Pricing Theory:

Introduction
The Arbitrage Pricing Theory (APT) was developed by Stephen Ross in the
early 70s. The APT is based on fewer or less restrictive assumptions than the
more familiar Capital Asset Pricing Model (CAPM). Its an alternative method
of asset/security pricing. It is also a more general model than the CAPM
allowing for more than one risk factors to underlie stock returns. However
the primary challenge in applying the APT is discerning the identity of the
priced factors operational in a particular equity market over a particular
period of time.
APT theory is based on the concept of arbitrage. Arbitrage implies
finding/availability of two securities which are essentially same but having
different prices/returns. In this situation it will be profitable for the investor
sell the expensive one. The theory is based on the premise that security
price adjusts as investors forms portfolios in search of arbitrage profits. And
when such opportunities of earning arbitrage profits are completely
exhausted, than the price of the security will be equilibrium.

Arbitrage Pricing Theory (APT)

Arbitrage Pricing Theory (APT) is an alternate version of Capital Asset Pricing
Model (CAPM). This theory, like CAPM provides investors with estimated
required rate of return on risky securities. APT considers risk premium basis
specified set of factors in addition to the correlation of the price of the asset
with expected excess return on the market portfolio.
As per assumptions under Arbitrage Pricing Theory, return on an asset is
dependent on various macro-economic factors like inflation, exchange rates,
market indices, production measures, market sentiments, changes in interest
rates, movement of yield curves etc.
The Arbitrage pricing theory based model aims to do away with the
limitations of one-factor model (CAPM) that different stocks will have
different sensitivities to different market factors which may be totally
different from any other stock under observation. In layman terms, one can
say that not all stocks can be assumed to react to single and same
parameter always and hence the need to take multifactor and their
sensitivities.
Calculating Expected Rate of Return of an Asset Using Arbitrage
Pricing Theory (APT)
Arbitrage Pricing Theory Formula E(x) = rf + b1 * (factor 1) +b2
*(factor 2) + .+ bn *(factor n)

Where,
E(X) = Expected rate of return on the risky asset
Rf = Risk-free interest rate or the interest rate that is expected from a riskfree asset
(Most commonly used in U.S. Treasury bills for U.S.)
B = Sensitivity of the stock with respect to the factor; also referred to as
beta factor 1, 2
N = Risk premium associated with respective factor
As the formula shows, the expected return on the asset/stock is a form of
linear regression taking into consideration many factors that can affect the
price of the asset and the degree to which it can affect it i.e. the assets
sensitivity to those factors.
If one is able to identify a single factor which singly affects the price, the
CAPM model shall be sufficient. If there are more than one factor affecting
the price of the asset/stock, one will have to work with a two-factor model or
a multi-factor model depending on the number of factors that affect the
stock price movement for the company.
To understand APT, it is important for us to learn the underlying assumptions
of this theory as given below.

Arbitrage Pricing Theory Assumptions

o The theory is based on the principle of capital market efficiency and
hence assumes all market participants trade with the intention of
profit maximisation
o It assumes no arbitrage exists and if it occurs participants will
engage to benefit out of it and bring back the market to equilibrium
levels.
o It assumes markets are frictionless, i.e. there are no transaction
costs, no taxes, short selling is possible and an infinite number of
securities is available.

Applying the APT

Finding Factors How do we apply the APT? One difficulty with the model it
is generality. We have left the simple world of the CAPM. We no longer know
exactly what sources of systematic risk people truly care about. On the other
hand, reading the financial section of the newspaper we can get idea. The
Wall Street Journal for instance, regularly reports on surprises in interest
rates, surprises in GNP, surprises in inflation and changes in the stock market

indices. All of these are candidates for APT factors. Indeed, we may not
actually need to identify the economy's risk factors. We only need to find a
collection of things that together are good proxies for them. After the
theoretical development of the APT, Chen, Roll and Ross set out on a quest
for the factors. They found that a collection of four or five macro-economic
series' that explained security returns fairly well. These factors turned out to
be surprises in inflation, Surprises in GNP, surprises in investor confidence
(measured by the corporate bond premium) and shifts in the yield curve. In
general these do as good a job at explaining returns as the S&P index. Of
course, no one really knows if these are the "true" factors. As the APT
continues to be used in practice, other variables are likely to be used. Once
factors are chosen, only the unanticipated portion of the factor is used for
estimating the APT model. As with the CAPM, we usually regress historical
security returns on the factor to estimate 's. These 's are used in a model
of expected returns to estimate the discount rate.
Building portfolios The APT is a useful tool for building portfolios adapted
to particular needs. For example, suppose a major oil company wanted to
create a pension fund portfolio that was insulated against shock to oil prices.
The APT allows the manager select a diversified portfolio of stocks that has
low exposure to inflation shocks (oil prices are correlated to inflation). If the
CAPM is a "one size fits all" model of investing, the APT is a "tailor-made
suit." In the APT world, people can and do have different tastes and care
more or less about specific factors.
Sensitivity analysis With the APT we can model the effects of different
economic scenarios on schange in security returns with respect to changes in
that factor. How will my portfolio perform in a recession? Am I exposed to
shifts in the yield curve? These are typical questions addressed by APT
analysis.

Let us now look at some arbitrage pricing theory advantages and

disadvantages summarized as under:

Arbitrage Pricing Theory Benefits

o APT model is a multi-factor model. So, the expected return is
calculated taking into account various factors and their sensitivities
that might affect the stock price movement. Thus, it allows selection
of factors that affect the stock price largely and specifically.

o APT model is based on arbitrage free pricing or market equilibrium

assumptions which to a certain extent result in a fair expectation of
the rate of return on the risky asset.
o APT based multi-factor model places emphasis on the covariance
between asset returns and exogenous factors, unlike CAPM. CAPM
places emphasis on the covariance between asset returns and
endogenous factors.
o APT model works better in multi-period cases as against CAPM which
is suitable for single period cases only.
o APT can be applied to the cost of capital and capital
budgeting decisions.
o The APT model does not require any assumption about the empirical
distribution of the asset returns, unlike CAPM which assumes that
stock returns follow a normal distribution and thus APT a less
restrictive model.

Arbitrage Pricing Theory Limitations

o The model requires short listing of factors that impact the stock
under consideration. Finding and listing all factors can be a difficult
task and runs a risk of some or the other factor being ignored. Also,
the risk of accidental correlations may exist which may cause a
factor to become substantial impact provider or vice versa.
o The expected returns for each of these factors will have to be arrived
at, which depending on the nature of the factor, may or may not be
easily available always.
o The model requires calculating sensitivities of each factor which
again can be an arduous task and may not be practically feasible.
o The factors that affect the stock price for a particular stock may
change over a period of time. Moreover, the sensitivities associated
may also undergo shifts which need to be continuously monitored
making it very difficult to calculate and maintain.

Conclusion
Arbitrage Pricing Theory-based models are built on the principle of capital
market efficiency and aim to provide decision makers and participants with
estimates of required rate of return on the risky assets. The required rate of
return arrived using the APT model can be used to evaluate, if the stocks are
over-priced or under-priced. Empirical tests conducted in the past have
resulted from APT as a superior model over CAPM in many cases. However, in
several cases, it has arrived at similar results as CAPM model, which is
relatively simpler in use.

References:

1.http://www.kellogg.northwestern.edu/faculty/papanikolaou/htm/FINC460/LN
/Lecture6.pdf
2.http://www.academia.edu/8030892/The_Capital_Asset_Pricing_Model_and_t
he_Arbitrage_Pricing_Model_A_critical_Review
3,http://mirceatrandafir.com/teaching/econ435/Chapter_11_6spp.pdf