Role of Arbitrage Pricing Theory in Modern Portfolio Management - Essay Example

ASSIGNMENT: Order Number Question 1 Critically assess the Role of Arbitrage Pricing Theory (APT) in Modern Portfolio Management. The Arbitrage Pricing Theory (APT), which was developed recently by Ross (1976), has offered a testable alternative to the world known, one period Capital Asset Pricing Model (CAPM) formulated by Sharpe (1964), Lintner (1965) and Black (1972). The Capital Asset Pricing Model was developed in the early 1960s. The Arbitrage Pricing Theory has been the most recent development in asset pricing model in modern portfolio management and is recognised as a direct alternative to CAPM. The CAPM has been predominant in its empirical work on the basis of the modern portfolio theory over the past years. But, in recent time, accumulation of research has increasingly express doubt on its validity to explain the empirical anomalies evidence of asset returns, which arise within CAPM. Despite the weakness of CAPM, it still remains a central model in the minds of academic scholar, portfolio managers, investment advisor and security analyst. (Ross and Roll, 1980). The two asset pricing models have some similarities and differences. For the concern of clarity, the major difference between the models stem from how APT treats the interrelationship of returns on securities. The APT model assumes the security returns are generated by a number of industry-wide and market-wide factors. That is, the correlation between a pair of securities occurs when the two securities are affected by the same factor(s). The contrasting aspect with CAPM to APT tells how the former allows the correlation among securities and does not specify the particular factors initiating the correlation. On the other hand, the common aspect of the two models shows how they recognise a positive relationship between expected return and risk. But to a serious note, APT allows this relationship to be developed in an intuitive manner. Besides, APT examines the risk in a more general way rather than just the standardized covariance or beta of a security with market portfolio. Therefore, with this development, APT is classified as an alternative model to CAPM. (Ross, Westerfield and Jaffe, 2002 pp, 285). The CAPM and APT has not yet been able to exhaust the models and techniques used in practice to measure the expected return on risky assets. They are both risk-based models and each of them measure the risk of a security by its beta(s) on some systematic factor(s) and they both argue that the expected return must be proportional to the beta(s). (Ross, Westerfield and Jaffe, 2002 pp. 300). The relatively strong demand of the APT most likely comes from its implication that compensation for bearing risk may be comprised of several risk premia, rather than just a single risk premium as shown in the CAPM. Ross and Roll (1979) in their work claimed to find empirically at least three and probably four factors that are priced from 1962 to 1972. However, they do not offer an economic interpretation of these factors and admit that their test is a weak one. (Reinganum, 1981). The arbitrage pricing theory (APT) has basically three assumptions. Firstly, assumes that the capital markets are perfectly competitive. Secondly, it considers how investors always prefer more wealth to less wealth with certainty. And, thirdly, the stochastic process generating asset returns can be represented as a k-factor model of the form: Ri = Ei + bi1δ1+ ... + bikδk + έi i for i = 1, ...,N where: Ri = return on asset i; Ei = expected return for asset i; bik = reaction in asset i’s returns to movements in the common factor δk; δk = a common factor, with a zero mean, that influences the returns on all assets; έi = an idiosyncratic effect on asset i’s return which, by assumption, is completely diversifiable in large portfolios and has a mean of zero; N = number of assets. In economic term, the argument of the APT is a simple one. In situation of equilibrium, the return on a zero-investment, zero-systematic-risk portfolio is zero, as long as the idiosyncratic effects vanish in a large portfolio. This economic reasoning, combined with theory from linear algebra, implies that the expected return on any asset i can be expressed as: Ei= λ0 + λ1bi1 + ... + λkbik The term λo can be viewed as the expected return on an asset with zero systematic risk (i.e., b0l = b0z= b0k = 0). The weights λl, .. . , λk can be interpreted as factor risk premia, and the bi's reflect the pricing relationship between the risk premia and asset i. In other words, the assets' expected returns are jointly based upon the assets' reaction coefficients and the common risk premia. (Reinganum,1981). The critical assessment of APT to modern portfolio management can be looked upon in the differences in its pedagogy and application to alternative model, in particular the CAPM. Considering the differences in pedagogy, the CAPM has a strong advantage for student’s point of view. This is because the derivation of CAPM is fascinating and brings the reader’s state of mind in a manner that understands the discussion of efficient set, which begins with tha case of two risky assets, moving to the case of many risky assets and ends when a riskless asset is added to the many risky ones. But notwithstanding, APT has an offsetting advantage. This is seen from the fact that the model or approach adds factors until the unsystematic risk of any security is uncorrelated with the unsystematic risk of every other security. Two key points are recognised under the formation of APT. Firstly, there is a steady fall of unsystematic risk as the number of security in the portfolio increases. And secondly, the systematic risk does not fall. (Ross, Westerfield and Jaffe, 2002 pp. 298) Furthermore, the differences in application are considered at this point. The one strong advantage of APT in that it can handle multiple factors, which is been ignored by CAPM. It is vital to understand that one factor model of APT is identical to the CAPM approach. The multifactor APT model is more realistic in practice. This is because it recognises many market-wide and industry-wide factors before the unsystematic risk of one security becomes uncorrelated with the unsystematic risks of other securities. (Ross, Westerfield and Jaffe, 2002 pp. 298) In conclusion, the arbitrage pricing theory (APT) so far has been able to offers a parametric alternative to the simple one period capital asset pricing model (CAPM). The critical role of APT in modern portfolio management, which is seen as a minimum empirical requirement for an alternative model, is that it provides a valid theoretical explanation on the empirical anomalies that arise within the CAPM. Question 2 You strongly believe that whenever the CEO of a company retires, an excess return can be made by buying the company’s stock. Describe how you would test this hypothesis. A change in executive leadership is a significant event in the life of a firm. A chief executive officer’s ability, preferences, and ultimate decisions affect the firm through the projects the firm selects, its financial policy, and the corporate culture. To the extent that these characteristics and the resulting decisions differ across individuals, CEO changes can alter the course of the firm and its performance. (Matthew, Jay and Joshua, 2003) The change of a CEO in an organisation can be considered differently in different situation. It can be either voluntary or non voluntary. The former situation considers the event of change when the CEO retires either expectedly or unexpectedly. While the later considers the event of a CEO been sacked or resigned. Both of the change events of the CEO have a different implication on the stock return demanded by equity holder, since their risk would increase to some extent. To be able to test the hypothesis of the above question, I have decided to dwell my argument based on the event of is a voluntary change of the CEO, which is in this case seen as a retirement. And a change of the CEO can either be internal (internal succession) or external (external succession). Each of the change has a different effect on equity volatility and thus initiating an impact on their stock return required. An internal change of the retired CEO can be considered as an ability phenomenon because shareholders want to maintain their risk level by appointing an insider to continue with the operations of the firm in a way the trust and familiar with. On the other hand, external succession of a retired CEO is considered a strategic phenomenon because shareholders would expect to get a full change in the company operations and performance. This is what makes big news to new stock buyers. Change is something very fascinating in the light of a firm’s performance growth and development. And the outcome of a change can be positive or negative. The absorption of the event of change by a firm would greatly depend on the nature of individual risk habits by the shareholders. The risk loving investors would demand change most of the time because it would create a level of volatility to their holdings and as such, they would demand a higher stock return. The idea is a mirror image to investors who are risk averse. It is often quoted “New CEO, Better Return”. The implication of this situation stem from the fact that equity investors expect a more better performance of the new CEO, especially when the firm has a good track record over the past years. The degree of optimism would earn excess return to existing equity holders and new stock buyers. References Ross, Westerfield and Jaffe (2002): Corporate Finance, McGraw-Hill, International Edition. Matthew, J.C, Jay, C.H, and Joshua, V.R (May 2003): The impact of CEO Turnover on Equity Volatility, Federal Reserve Bank of New York Staff Report, Issue NO. 166. Ross, S.A, and Roll, R (1980): An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, Vol. 35, No. 5, pp. 1073-1103. Reinganum, M.R (May 1981): The Arbitrage Pricing Theory; Some Empirical Results, Journal of Finance, Vol. 36, No. 2, Papers and Proceedings of the Thirty Ninth Annual Meeting American Finance Association, Denver, September 5-7, 1980, pp. 313-321. Glen, A (2005): Corporate Financial Management, Prentice Hall, England. Third Edition Read More