Arbitrage Theory of Capital Asset Pricing - Literature review Example

?The Arbitrage Theory of Capital Asset Pricing Introduction In finance, capital asset pricing models are used to describe the relationship between risk and expected rate of return while dealing with pricing of risky securities. In simple words, this method is helpful to compute the required rate of return of an asset when that asset is invested with a business venture. The capital asset pricing method offers some productive concepts. According to this concept, the investors have to be compensated on the strength of their time value of money and risk. Time value of money represents the period of time an investor placed his money in any investment. At the same time, the risk factor offers price to investors for investing their money in risky securities. The sum total of both these factors gives a clear view regarding the expected rate of return on a particular asset. It is generally calculated by using a risk measure called beta. The arbitrage pricing theory is a well known alternative to capital asset pricing model that is beneficial for the investors to determine whether an asset is correctly priced or not. This paper tends to evaluate various aspects of the arbitrage theory of capital pricing. Structure of Arbitrage Pricing Theory Arbitrage Pricing Theory (APT) is an alternative to capital asset pricing theory and it is formulated by the economist Stephen Ross in 1976. In order to clearly evaluate the potentiality of arbitrage pricing theory, it is necessary to understand the range and terms of capital asset pricing model (CAPM). As discussed above, CAPM calculates rate of return of an asset by adding the value of risk taken with duration of investment. It is relevant to understand the working method of CAPM also. Assume that risk-free rate is 5%, the beta measure of the stock is 3 and the expected rate of market return for this period is 12%; then the expected rate of stock becomes: 5%+3(12% - 5%) = 26% In the opinion of Roll and Ross (1980), this theory had considerable significance in empirical work during the periods of 1960’s and 1970’s. However further researches on this concept have questioned its reliability and authenticity of the computation of empirical constellation of asset returns; and, many related theories have detected ranges of disenchantment with the CAPM (ibid). Authors say that this situation led to the demand for a more potential theory and it caused the formulation of APT. Although, APT was developed recently, CAPM is considered as the basis of modern portfolio theory. Huberman and Wang (2005) claim that both the CAPM and APT show relation between expected returns of assets and their co-variance with other random variables; and an investor cannot avoid some types of risks by diversification and the concept of covariance is interpreted as a measure of such risks. While comparing with CAPM, the APT contains fewer assumptions; and at the same time, this theory is very difficult to use. Roll and Ross (1980) clearly tells that the basic idea behind arbitrage pricing theory is that the price of a security is varied by mainly two groups of factors such as macro factors and company specific factors. Since no ‘arbitrage assumptions’ are employed, this theory is popularly known in this name. The group categorization and thereby macro as well as company specific factors are very crucial to form the following formula: r = rf + ?1f1 + ?2f2 + ?3f3 + … where r represents the expected rate on the security and rf is the risk free rate. In this formula, f stands for a separate factor and ? is a relationship measure between the security price and that factor. Cho, Eun, and Senbet (1986) have conducted an empirical investigation so as to evaluate the international performance of the arbitrage pricing policy. In their research, they mainly employed two valuation techniques such as inter-battery factor analysis and Chow test. The inter-battery factor analysis helped the authors to estimate the international common factors while they could test the validity of the APT using Chow test method. A large numbers of researches have been conducted with intent to extend the ATP to an international setting. In their study, Cho, Eun, and Senbet also analyze the validity of arbitrage pricing policy in an international setting. According to authors, the results obtained from inter-battery factor analysis reflect that international common factors range from one to five between a pair of countries. At the same time, the cross-sectional test results bring out the point that international capital market is not integrated and thereby the ATP is not an internationally valid concept (ibid). There major difference between CAPM and ATP is that there is only a single non-company factor and a single beta for CAMP while ATP separates out non-company factors adequately. Each beta represents the price sensitivity of the security to that factor. APT employs the expected return of the risky assets and the risk premium of a variety of macroeconomic factors while the CAPM formula uses market’s expected return only. Under APT, arbitrageurs take advantages of the mispriced securities as it would have a price that deviates from the theoretical price predicted by the model. It is essential to note that APT does not rely on the measurement of market performance. Instead, the APT directly focuses on the fundamental factors that influence the price of the security. According to Huberman and Wang, arbitrage pricing theory argues that “if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the factor loadings” (Huberman & Wang ,2005 p.1). This theory is precisely based on the preclusion of arbitrage. The authors continue that if there is a linear relationship between expected returns and the betas, it precisely expresses the detection of the scholastic discount factor. Benefits of Arbitrage Pricing Theory The introduction of APT brought some notable changes in the field of economics. The requirements of APT theory are not much restrictive as in the case of CAPM. Under CAPM, it imposes certain strict restrictions regarding individual portfolios; but APT adopts a more liberal approach to this requirement. In the opinion of Ingersoll (1984), the APT derives a simple linear pricing relation and it can be considered as the one of the key advantages of APT. The simplicity of this method enables the investors to easily apply it. We have discussed that this concept examines a variety of macro economic factors for the purpose of asset pricing, and it adds to the authenticity of the results obtained through the application of this theory. Paavola (2006) argues that the use of diverse macroeconomic factors benefits an investor in many ways. These macroeconomic factors are very beneficial to deal with economic interpretation and it is difficult in the case of a factor analysis approach. Since the observed macroeconomic factors introduce addition information, it can be effectively employed to explain asset-prices in addition to the actual asset-prices (ibid). It is obvious that APT constitutes a world of arbitrageurs and vendors and their information. The APT is less restrictive while dealing with those information structures also. Some scholars claim that this theory is easily testable as it does not demand the market portfolio measurement. Many theories of that period failed due to the difficulties associated with its mathematical computation; but this new concept does not raise such issues. Dhrymes, Friend, and Gultekin (1984) strongly opine that APT is recommendable to explain the anomalies seen in the CAPM application to asset returns. In the words of Chesney, Gibson, and Louberge (1995), arbitrage trading can be reflected as one of the major benefits of APT. Arbitrage trading is the act of buying or selling a security within the trading day with intent to take advantages of differences in values resulting from market fluctuations. Under this method, the arbitrage trader purchases a particular security and sells the same or a closely related one at the same time (ibid). Since the modern market is subject to frequent fluctuation, the arbitrage trading based on the concept of APT is much helpful to every business organization aims at attaining stability. This theory also helps to deal with selling and purchasing similar financial instruments and thereby earning profit on the discrepancies in currency prices. The tool used to carry out this process is called forex arbitrage calculators. Arbitrage trading is a broader area and the APT largely contributes to this field. Limitations of Arbitrage Pricing Theory Every theory will have some pit falls in addition to its stronger areas; and it is applicable in the case of APT also. According to Ingersoll (1984), the APT fails to explain what might be the important factors and how to interpret factor premiums that constitute significant part of pricing equation. These inadequacies of information produce lot of difficulties to the investors to conduct a detailed study into investment decision. According to APT, investors perceive the sources of risks so that they can reasonably analyze the factor sensitivities. In actual practice, this provision seems to be ineffective as the identity of risk factors cannot be realized. Dhrymes, Friend, and Gultekin (1984) argue that many of the limitations associated with CAPM or any other theory are also visible in ATP. Like any other theories, the authenticity of arbitrage pricing theory also very much depends on its potentiality to explain the relevant empirical evidence. It has been identified that this theory raises questions regarding its testability in an international setting. The authors add that “a major part of the problem results from the necessity to break down the ‘universe’ being analyzed through the APT model” (Dhrymes, Friend, and Gultekin, 1984, p.323). The outcomes realized from the research of Shanken (1982) largely support the views and findings of Dhrymes, Friend, and Gultekin. According to Shanken (1982), the ATP is not more susceptible to empirical verification than the CAPM. The author also challenges the testability of arbitrage pricing theory as he finds that the basic elements of testability strategy would not properly work in the case of this model. He also points out that the theory precludes the differentials of expected return that form the basic structure of the concept (ibid). The APT theory works on a major assumption that markets are perfectly competitive and frictionless. This condition may not exist in every market condition because of some factors. Under such circumstance, the application of the APT theory would not produce some fruitful results. Moreover, APT is not well defined as in the case of CAPM. Scope of Arbitrage Pricing Theory Although, some limitations minimize the potentiality of APT, one can doubtlessly say that APT would help modern investors to a large extent. It is advisable to conduct further researches on this topic to generate more ideas regarding various macroeconomic factors and the extent of impact on the asset prices. Economists must try to modify the structure of the concept to test the reliability of this theory in an international market setting. While modifying the concept, the researchers must be careful to include provisions regarding recent market fluctuating stimulants. Conclusion We discussed two asset pricing models in this paper; Capital Asset Pricing Method (CAPM) and Arbitrage Pricing Theory (APT). The APT was developed to overcome the limitations of the CAP and it was fundamentally based on the concepts of CAPM. The most fascinating feature of the APT is that it was constructed on the strength of fewer assumptions so that there is only less chance of faulty interpretations. The macro economic factors and the company specific factors play a great role in the function of arbitrage pricing formula. The various researches reflect that this theory is not much testable in an international setting. However, this theory is almost accurate in asset pricing as it considers a variety of macroeconomic factors unlikely in the case of CAPM. The arbitrage trading has been identified as one of the fruitful applications of APT. This theory will be very beneficial for investors if it is restructured including effective modifications. References Cho, DC., Eun, CS & Senbet, LW 1986, “International arbitrage pricing theory: An empirical investigation”, The Journal of Finance, Vol. 41, No. 2, pp. 313-329 Chesney, M., Gibson, R & Louberge, H 1995, “Arbitrage trading and index option pricing at soffex: An empirical study using daily and intradaily data”, Finanzmarkt and Portfolio Management-9, viewed 31 March 2011 Dhrymes, PJ., Friend, I & Gultekin, NB 1984, “A critical reexamination of the empirical evidence on the arbitrage pricing theory”, The Journal of Finance, Vol. 39, No. 2, pp. 323-346. Huberman, G & Wang, Z 2005, “Arbitrage pricing theory”, Federal Reserve Bank of New York Staff reports, no. 216, viewed 31 March 2011 Ingersoll, JE 1984, “Some results in the theory of arbitrage pricing”, The Journal of Finance, Vol. 39, No. 4, pp. 1021-1039 Paavola, M 2006, “Tests of the arbitrage pricing theory using macroeconomic variables in the Russian equity market”, Department of Business Administration Section of Accounting and Finance, Lappeenranta University of Technology, viewed 31 March 2011 Roll, R & Ross, S 1980, “An empirical investigation of the arbitrage pricing theory”, The Journal of Finance, Vol. 35, No. 5, pp.1073-1103. Shanken, J 1982, “The arbitrage pricing theory: Is it testable?” The Journal of Finance, Vol.37, No.5, pp. 1129-1140 Read More