What is Arbitrage Pricing Theory?
Firstly, the Arbitrage Pricing Theory (APT) is a theory of asset pricing. That states that an asset’s returns can be forecasted with. The linear relationship of an asset’s expected returns as well as the macroeconomic factors. That impacts the asset’s risk. This theory offers analysts and investors. A multi-factor pricing model for securities, depending on the. Relationship of an asset’s expected return and its risk. Also, the Arbitrage Pricing Theory was created in 1976 by. American economist, Stephen Ross.
Understanding Arbitrage Pricing Theory
Furthermore, the Arbitrage Pricing Theory seeks to identify. The fair market price of a security may be temporarily incorrectly priced. It is of the opinion that market action is less than always perfectly efficient. And therefore occasionally results in assets being mispriced be it. Overvalued or undervalued for a short period of time.
Howbeit, market action is expected to correct the situation. Moving the price back to its fair market value. ALSO, understand that to an arbitrageur. Temporarily mispriced securities represent the short-term. Opportunity to profit virtually risk-free.
Also, the Arbitrage Pricing Theory comes as more flexible. And complex options to the Capital Asset Pricing Model (CAPM). The theory offers investors and analysts a. Medium of customizing their research. Howbeit, it is more difficult to apply. As it takes a considerable amount of time to. Determine all the various factors which may influence the price of an asset.
The Formula for the APT model is:
E(R)i = E(R)z + (E(I) – E(R)z) × Bn
E(R)i = Expected return on the asset
Rz = Risk-free rate of return
Bn = Sensitivity of the asset price to macroeconomic factor n
Ei =Risk premium associated with factor i
Moreso, the beta coefficients in the APT model are estimated. Using linear regression. On the whole, historical securities returns are regressed. On the factor to estimate its beta.
Maths Model for the APT
Even though APT is more flexible than the CAPM. It is more complex. This is because the APT formula has multiple factors. Take an amount of research to see how sensitive. Good security is to various macroeconomic risks.
Also, the factors as well as how many of them are used are choices. Also, this implies that investors will have varying results based on their choice. Be it as it may, four or five factors will usually explain most of a security’s return.
Lastly, APT factors are the risk that cannot be reduced by the diversification of an investment portfolio. Furthermore, the macroeconomic factors which have proven to be most reliable as price predictors include unexpected changes in inflation, gross national product (GNP), corporate bond spreads, and shifts in the yield curve. Other commonly used factors include the gross domestic product (GDP), commodities prices, market indices, as well as exchange rates.