Arbitrage Pricing theory

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an
alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume
markets are perfectly efficient, APT assumes markets sometimes misprice securities, before
the market eventually corrects and securities move back to fair value. Using APT,
arbitrageurs hope to take advantage of any deviations from fair market value. However, this
is not a risk-free operation in the classic sense of arbitrage, because investors are assuming
that the model is correct and making directional trades – rather than locking in risk-free
profits.

Mathematical Model of the APT

While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into
account one factor — market risk — while the APT formula has multiple factors. And it
takes a considerable amount of research to determine how sensitive a security is to various
macroeconomic risks. Which factors, and how many of them are used, are subjective choices
– which means investors will have varying results depending on their choice. However, four
or five factors will usually explain most of a security's return. (For more on the differences
between the CAPM and APT, read CAPM vs. Arbitrage Pricing Theory: How They Differ)

APT factors are the systematic risk that cannot be reduced by the diversification of an
investment portfolio. The macroeconomic factors that have proven 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 are gross domestic
product (GDP), commodities prices, market indices and exchange rates.

The Arbitrage Pricing Theory Model:

Where:

E(rj) – Expected return on asset

rf – Risk-free rate

ßn – Sensitivity of the asset price to macroeconomic factor n

RPn – Risk premium associated with factor n

The beta coefficients in the APT model are estimated by using linear regression. In general,
historical securities returns are regressed on the factor to estimate its beta.

For example, the following four factors have been identified as explaining a stock's return,
and its sensitivity to each factor and the risk premium associated with each factor have been
calculated:
Gross domestic product growth: ß = 0.6, RP = 4%

Inflation rate: ß = 0.8, RP = 2%

Gold prices: ß = -0.7, RP = 5%

Standard and Poor's 500 index return: ß = 1.3, RP = 9%

The risk-free rate is 3%.

Using the APT formula, the expected return is calculated as:

Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

List of the Advantages of Arbitrage Pricing Theory

1. It has fewer restrictions.

The APT does not have the same requirements about individual portfolios as other predictive
theories. It also has fewer restrictions regarding the types of information allowed to perform
predictions. Because there is more information available, with fewer overall restrictions, the
results tend to be more reliable with the arbitrage pricing theory than with competitive
models.

2. It allows for more sources of risk.

The APT allows for multiple risk factors to be included within the data set being examined
instead of excluding them. This makes it possible for individual investors to see more
information about why certain stock returns are moving in specific ways. It eliminates many
of the questions on movement that other theories leave behind because there are more sources
of risks included within the data set.

3. It does not specify specific factors.

Although APT does not offer specific factors like other pricing models, there are four
important factors that are taken into account by the theory. APT looks at changes in inflation,
changes in industrial production, shifts in risk premiums, and shifts in the structure of interest
rates when creating long-term predictive factors.
4. It allows for unanticipated changes.
APT is based on the idea that no surprises are going to happen. That is an unrealistic
expectation, so Ross included an equation to support the presence of an unanticipated change.
That makes it easier for investors to identify assets which have the strongest potential for
growth or the strongest potential for failure, based on the information that is provided by the
opportunity itself.

5. It allows investors to find arbitrage opportunities.

The goal of APT is to help investors find securities in the market that are mispriced in some
way. Once these can be identified, it becomes possible to build a portfolio based on them to
generate returns that are better than what the indexes are offering. If a portfolio is then
undervalued, the opportunities can be exploited to generate profits because of the changes in
the pricing theory.

List of the Disadvantages of Arbitrage Pricing Theory

1. It generates a large amount of data.

For someone unfamiliar with the arbitrage pricing theory, the amount of data that needs to be
sorted through can feel overwhelming. The information is generated by a specific analyzation
of the various factors involved that create growth or loss, allowing for the predictive qualities
to be factors in portfolio decisions. Someone not familiar with the purpose of each data point
will not understand the results APT generates, which makes it a useless tool for them.

2. It requires risk sources to be accurate.

Every portfolio encounters some level of risk. For APT to be useful, it requires investors to
have a clear perception of the risk, as well as the source of that risk. Only then, will this
theory be able to factor in reasonable estimates with factoring sensitivities with a higher level
of accuracy. If there is no clear definition of a risk source, then there will be more potential
outcomes that reduce the effectiveness of the predictive qualities that APT provides.

3. It requires the portfolio to be examined singularly.

The APT is only useful when examining a single item for risk. Because of that feature, trying
to examine an entire portfolio with diverse investments is virtually impossible to do. That is
why the entire portfolio is examined using the arbitrage pricing theory instead. Because it
doesn’t account for each account, only the portfolio, there are certain assumptions which
must be made during the evaluation. That can lead to factors of uncertainty, which reduces
the accuracy of the outcomes being analyzed.

4. It is not a guarantee of results.

The arbitrage pricing theory does not guarantee that profits will happen. There are securities
which are undervalued on the market today for reasons that fall outside of the scope of what
APT considers. Some risks are not “real” risks, as they are built into the pricing mechanisms
by the investors themselves, who have a certain fear of specific securities in certain market
conditions.

The advantages and disadvantages of the arbitrage pricing theory are designed to look at the
long-term average of returns. There are a handful of systematic influences which can affect
this long-term average. By looking at the asset and the risks involved, a prediction of an
anticipated return becomes possible. It is a good option for individual securities. When a
portfolio of diverse securities is examined, however, APT may not be a suitable tool to use.