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Arbitrage Pricing Theory & Multi Factor Model

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39 views10 pages

Arbitrage Pricing Theory & Multi Factor Model

Uploaded by

ishabaruahgk
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Arbitrage Pricing

Theory & Multi


Factor Model
Group Members:
Drisha Boruah
Nupur Saha
Purnima Debnath
Palash Borah
MEANING
Arbitrage pricing theory (APT) is a multi-factor asset pricing
model based on the idea that an asset's returns can be
predicted using the linear relationship between the asset’s
expected return and a number of macroeconomic variables
that capture systematic risk. It is a useful tool for analysing
portfolios from a value investing perspective, in order to
identify securities that may be temporarily mispriced.
Reason for its Development
• Arbitrage pricing theory was mainly developed for addressing the
“single factor” criticism of CAPM.
• Compared to CAPM, APT has fewer assumptions.
• Unlike CAPM, which tells that the required return on stock is
guided by market returns alone, APT proposes that required return
on stocks are ruled by many macroeconomic unbiased factors.
• APT is also very useful for building portfolios because it allows
managers to test whether their portfolios are exposed to certain
factors.
THE MULTI-FACTOR MODEL:

E(R)=Rf+P1β1+P2β2…………..Pnβn

E(R) – Expected return on the asset


Rf – Risk-free rate of return
ßn – The level of volatility of an asset’s price with respect to
factor n, which is a macroeconomic variable causing
systemic risk; how sensitive the asset is to factor n
Pn – Risk premium of factor n.
MACRO-ECONOMIC FACTORS
FOR APM:
Changes in level of industrial production in the economy.
Changes in the shape of the yield curve.
Changes in the default risk premium
Changes in the inflation rate.
Changes in the real interest rate.
The level of personal consumption.
The level of money supply in the economy.
ASSUMPTIONS
There is perfect competition in the market, no
transactions cost are present.

The investors have homogeneous


beliefs/expectations.

The investors are risk averts utility maximizers.

The security returns are generated according to a


factor model.

Risk-returns analysis is not the basis.


BENEFITS
APT model is a multi-factor model.
APT model is based on arbitrage-free pricing or market equilibrium
assumptions.
The APT based multi-factor model places emphasis on the
covariance between asset returns and exogenous factors.
The APT model works better in multi-period.
APT can be applied to the cost of capital and capital
budgeting decisions.
The APT model does not require any assumption about the
empirical distribution of the asset returns.
LIMITATIONS
• The model requires a short listing of factors that impact the stock
under consideration.
• 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.
• The model requires calculating sensitivities of each factor which
again can be an arduous task and may not be practically feasible.
• The factors that affect the stock price for a particular stock may
change over a period of time.
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 the 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 the CAPM model, which is relatively
simpler in use.
THANK YOU

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