The Arbitrage Pricing Theory - Essay Example

How Good Is The Arbitrage Pricing Theory As An Asset Pricing Model? Table of Contents Introduction 3 Brief Introduction to the Asset Pricing Theory (APT) 4 Factors Models of Asset Returns 4 Example 5 Application of Arbitrage Pricing Theory 6 Measuring the Goodness of APT as an Asset Pricing Model 7 Empirical Evidences 7 Conclusion 9 References 10 Introduction The essay describes the goodness of Arbitrage Pricing Model as an Asset Pricing Theory. This can be described by a short introduction to the initial theory of Arbitrage Pricing and deriving the benefits of it over other relevant methods of asset pricing. The Asset Pricing Theory (APT) is an extension model to the CAPM or Capital Asset Pricing Model where it attempts to overcome certain flaws of the CAPM. The essay focuses mainly on the applicability of the theory in modern times and its fitness as an appropriate method of asset pricing. The practical implementation of the model will be taken up as the core of discussion rather than detailing the theoretical aspects of the model. Brief Introduction to the Asset Pricing Theory (APT) The APT assumes distribution of return on assets and is based on the reliability towards approximate arguments on arbitrage. Particularly the APT bases assumption on a factor model of asset returns which is as follows: Factors Models of Asset Returns First the model assumes that asset returns are determined by a few common factors (k) and distinctive noise: Ri= Ei+Bi1F1+..........BikFk+Ui (i=1, 2, 3........) Where, Ei is the expected return on asset i F1... Fk are news on common factors that drives all asset returns Bik measures the sensitivity of return on assets i towards news on the k-th factor Ui is the distinctive component in the return on asset i which is unrelated to other asset returns It must be noted that F1, F2... Fk and Ui have zero mean Thus, E [Fk] = 0 E [Ui] = 0 (Prof. Derdenger, n.d.). Example The common factors that drive asset returns may be the GNP, interest rates, inflation. Let Fint be the interest rates news. Suppose there will be a board meeting of the Fed. Before the board meeting, the market will expect that there will be no changes on the interest rates. And after the meeting, it has been announced that There will be no change in the interest rates – ‘no news’ Implies: Fint = 0 There will be ¼ % increase in the interest rates – ‘positive surprise’ Implies: Fint = 0.25 % > 0. (Wang, 2003). Application of Arbitrage Pricing Theory The two most common areas of application of the asset pricing frameworks are the event study and performance evaluations. The event study can be performed by the factor model of APT. A typical event study time line Using the market model, event studies provide evidences of the reaction of the market to stock prices and earnings statement. The market presumes the information and prices are adjusted even before the news or the event is declared in the market. After the announcement of the news, the remaining price gets adjusted. The APT helps in demonstrating that prices not only represents estimates of performance but also the information. Measuring the Goodness of APT as an Asset Pricing Model The APT is very useful in measuring the fluctuations of historical share prices along with the market, especially during the beginning of bear and bull market. APT can be used by the investors for planning various investment strategies based on the short-term and long-term goals of the investor (Donovan, 2007). Empirical Evidences The APT has been empirically tested based on two approaches. The first approach used the technique of factor analysis in determining stock returns for discovering the basic factors. These were then evaluated to find whether there is correspondence to any economic variables. The empirical studies showed that there is very less consistency in terms of: The number of basic factors The understanding that can be applied to these factors The constancy of theses factors from one test to another The second approach specified factors as a ‘priori’ rather than found out by evaluating returns on stocks. The model work by Roll and Ross (APT) characterised the approach. Four factors were employed by them: industrial production, inflation rate, term structure of interest rates and default risk premium. Sensitivity to uncertain changes in these factors explained the differences in expected returns among stocks in their study. The betterment of APT than any other asset pricing model has been supported by many scholars. As Bower & Et. Al., states that APT is better than CAPM which quantifies risk in terms of a single factor, beta, but APT explains sensitivity of asset returns by using several economic variables. APT assumes that asset returns are produced by a factor model but fails to identify the factors. But it is better than the CAPM that assumes only one factor affecting risk. Various studies indicated that stock prices are affected by various economic variables in the market and not just the market risk. The APT implies that assets with same sensitivity to risks should offer the same return. If it does not, then investors will take the advantage of arbitrage opportunity prevailing in the international market. According to Cauchie & Et. Al. (2002), a study was conducted on investigating the determinants of asset returns in an economy by the APT framework. The data were collected from the Swiss market over the period 1986-2000. They included both indices of industrial sectors and macro-economic data. The result of the study showed that Swiss equity returns were affected by both domestic and global economic conditions (Cauchie & Et. Al., 2002). According to Lee & Cummins (1998), APT performs better than CAPM for estimation of the cost of equity capital for the PC insurers (Lee & Cumins, 1998). Conclusion The essay has totally focused on the advantages of APT over other models and has presented both the pros and cons of the theory. Over the years the various theory of asset pricing has passed through many controversies in order to find out the most effective one. A very simple approach has been made towards the findings of goodness of APT as an asset pricing model. The APT is definitely a modern approach towards finding the factors affecting risk. The scope of the model is also very large as in modern times a number of factors dwell in the economy that has to become the affecting factors towards the determination of asset returns. References Cauchie, S. & Et. Al., 2002. The Determinants of Stock Returns: An Analysis of Industrial Sector Indices. University if Geneva, International Center FAME and University of Aberdeen. [Online] Available at: http://www.fmpm.org/docs/5th/Cauchie_Hoesli_Isakov.pdf [Accessed December 03, 2010]. Donovan, E., 2007. Capital Asset Pricing Model (CAPM) vs. Arbitrage Pricing Theory (APT). Touro University International. [Online] Available at: http://www.eddiedonovan.com/publications/FIN501MOD3CASE.pdf [Accessed December 03, 2010]. Lee, A. C. & Cummins, D., 1998. Alternative Models for Estimating the Cost of Equity Capital for Property/Casualty Insurers. Econpapers. [Online] Available at: http://econpapers.repec.org/article/kaprqfnac/v_3a10_3ay_3a1998_3ai_3a3_3ap_3a235-67.htm [Accessed December 03, 2010]. Prof. Derdenger, No Date. Lecture of Arbitrage Pricing Theory. Carnegie Mellon University. [Online] Available at: http://www.andrew.cmu.edu/user/derdenge/73440/APT.pdf [Accessed December 03, 2010]. Wang, J., 2003. Arbitrage Pricing Theory (APT). Road Map. [Online] Available at: http://web.mit.edu/15.407/file/Ch12.pdf [Accessed December 03, 2010]. Read More