The Role of the Arbitrage Pricing Theory in Modern Portfolio Management - Term Paper Example

College: PORTFOLIO MANAGEMENT The role of the Arbitrage Pricing Theory (APT) in modern portfolio management. APT is an example of non-mean variance management model. It is a theory that assumes that when assets have equal risks, then the investor can chose to arbitrage away any return differences as these are impacted on by systematic issues that are definite. Maximization is not a priority in this case. Thus the return generating process is frequently impacted on by factors like oil price movements and varying interest rates. (Basu 663). Therefore the APT will have many roles. First, in the management of priced portfolio and unpriced portfolio. Since returns on security has got both general and minor factors that affect it, it has been noted that there will be minimal effects as portfolio's become bigger and as far as assets returns are concerned. Thereafter the effects on smaller securities will be masked by those of larger portfolio. (Gruber 26). This is not to imply that returns will increase with sensitivity to the said factors. Because some factor that are prices cannot be diversified yet are persuasive, they will definitely affect the price returns as opposed to those that are unpriced yet can be diversified. Therefore the distinction of priced and unpriced factors defines the first role of APT in portfolio management. An example of this role in deciding to buy steels that are not persuasive to current prices, is for the APT manager to decide how to buy knowing they will not get extra returns. (Gruber 26), (Anonymous 337 - 352) Secondly, the manager must ensure that there is enough knowledge of choosing steel stocks to cover the extended risks and must also ensures that this risk is spread across several securities. Thus, the APT process must guarantee trade offs as prices make returns sensitive. This means that there is neither a good or bad decision, rather, risk return aim are the most guiding factors. (Gruber 26). Thirdly, APT will influence choice of portfolio depending on income. Thus, if the investor has substitute income other than the main investment portfolio, and that this income has impact on the investment security returns, these risks will be reduced subject to the sensitivity of the investment portfolio being low with regard to income. (Gruber 26) Therefore by use of Arbitrage Pricing Theory, the management will lay out a portfolio that considers several factors of influence under the prevailing market conditions. Thereafter priced risks will persuade the investor to take the greatest risk similar to CAPM. Risk will vary with sensitivity of the influences. However the market portfolio has no significance role in the decision of market performance. (Gruber 27). Hypothesis: Whenever the CEO of a company retires, an excess return can be made by buying the company's stock. This hypothesis can be tested by research into the retirement of famous CEO of companies that are listed in the stock exchange markets. Examples of key CEOs who have retired are Lee Raymond from Exxon Mobil (XOM), John Kanas from North Folk Bancorp, Robert Nardelli from Home Depot, Stan O'Neal from Merrill Lynch. A list of up to 50 CEOs who have retired from listed companies will need to be made to make up study of individual retirement and stock sale cases. (Oduma 1) Next research will need to be done to establish which which stocks sales went up or down as soon as the CEO of the respective companies retired from the listed companies. The assumptions to be held are that the stock quantities are stable as well as there price fluctuations. If more than 50% of these results reflect this statement, then the hypothesis can be said to hold. If not then the hypothesis in null. (Oduma 1) A long side this research, there will be need to identify factors that have previously led to increased buying of company stock. In this case, the issue of CEO's retirement will need to come up as one of the prominent factors. This will be done from a grounded theory point of view of secondary literature. Some of the factors that must also be considered are the type of company that is selling stocks. The real estate is one sector that is known to give excess returns as most of its markets offer arbitrage profits even in the midst of wrong pricing. They prices are always in the appreciation trend. (Oduma 1) The next thing to be tested in this hypothesis is the timing strategy of the stock market and whether that has any relations to the exit of a CEO. It is common knowledge that whenever stocks are offered to the private investors, excess returns will be made. Thus with speculations, when a CEO retires, there might be public feeling that the board had let them go as they were not making most returns by holding on to stocks. (Oduma 1) Special note will have to be made on other factors that can cause excess returns from stock buying. If the Company is a good one then excess returns will be made as opposed to a bad one. Selva (2002) noted that such thesis will rely on the public's classification of the stock company under the prevailing stock market conditions. In this case they will no be relying on the classification by the financial companies of the risks nor the speculated company performance. (Selva 1). The other condition that needs to be examined is whether the CEO is retiring due to an impending merger with another company. It was established that risk arbitrage returns had a direct relationship with the markets returns where markets were slow and depreciating yet the same effect was not seen in the flat markets that were picking up. Therefore they attributed these extra returns to the sales of uncovered index that CEOs' do put as options. Therefore when a CEO retires then this may be leading to excess buying of stock returns. Risk Arbitrage has been found to generate up to 4% excess returns per annum as a justification of contingency. (Mitchel & Palvino 2135-2175). If at that time the stock transaction cost have been set above the greater social correlation cost then there might be excess return from buying of stocks as was observed by Jennergren & Korvald (1975). Secondly if the buying rules are stiff, then the excess returns may not be realized. Some stock market expects people to buy and sell when price move by certain fixed percentage in areas that have filter rules. (Ka-chin Online) Finally, there is the issue of short-termism which may affect returns from bought stock. in the earlier decades, stocks were deliberately mis- priced based on some short term gain. However some countries have now put regulations to this behavior. The proponents who may be more interested with the short term rather than the long term may be quick to invest in the stock during the time of transition from one CEO to the next. These are opportunistic behavior that coupled with speculation can lead to excess returns from stock buying. (Ka-chin, Online). Cited Work List: Arthur Oduma, Earning Excess Returns in Real Estate: The case of investing in net lease Property REITS. Available at http://news.morningstar.com/artclenet/article.aspx=14668. Accessed on March 15, 2008. Basu, S. The relationship between earnings yield market value and the return for NYSE common Stock: Further Evidence. Journal of Finance 32 (1977):663. Gruber, Martin, J. Modern Portfolio Theory. 2003. Update from "Lessons of Modern Portfolio Theory" by Edwin J. Elton and Martin Gruber, which appeared in Modern investment management and the Prudent Man Rule by Bevis Longstreth. International Capital Markets Equilibrium With Investment Barriers Journal of Financial Economics (1974): 337 -352. Mitchell, Mark & Pulvino, Todd. Characteristics of Risk and Return in Risk Arbitrage The Journal of Finance (2001). Vol. 56 (6) , 2135-2175 doi:10.1111/0022-1082.00401 Ka-Ching. Market Efficiency. May 2006. Available at http://www.greekinvestment.com/web/index.php option=com_content&task+=view&id=43&itemid=123 . Accessed on March 15, 2008. Selva, Mohan Mohan, "Earnings and Stock Selection" (May 2002). City University of Hong Kong Department of Accountability Working Paper. Available at SSRN: http://ssm.com/abstract+314140 or DOI:10.2139/ssrn.314140 Read More