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Arbitrage pricing theory is one of the tools used by the investors and
portfolio manager. The capital asset pricing theory explains the return of the
securities on the basis of their respective betas. According to the previous
models, the investor chooses the investment on the basis of expected return
and variance. The alternative model developed in asset pricing by Stephen
Ross is known as Arbitrage Pricing Theory. The APT theory explains the
nature of equilibrium in the asset pricing in a less complicated manner with
fewer assumptions compared to CAPM.
Arbitrage
Arbitrage is a process of earning profit by taking advantage of differential
pricing for the same asset. The process generates riskless profit. In the
security market, it is of selling security at a higher price and the
simultaneous purchase of the same security at a relatively lower price. Since
the profit earned through arbitrage is riskless, the investors have the
incentive to undertake this whenever an opportunity arises. In general, some
investors indulge more in this type of activities than other. However, the
buying and selling activities of the arbitrageur reduce and eliminate the
profit margin, bringing the market price to the equilibrium level.
The Assumptions
1. The investors have homogeneous expectations.
2. The investors are risk averse and utility maximisers.
3. Perfect completion prevails in the market and there is no transaction
cost.
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The APT theory does not assume (1) single period investment horizon, (2)
no taxes, (3) investors can borrow and lend at risk free rate of interest and
(4) the selection of the portfolio is based on the mean and variance analysis.
These assumptions are present in the CAPM theory.
Arbitrage Portfolio
According to the APT theory an investor tries to find out the possibility to
increase returns from his portfolio without increasing the funds in the
portfolio. He also likes to keep risk at the same level. For example, the
investor holds, A, B and C securities and he wants to change the proportion
of the securities without any additional financial commitment. Now the
change in proportion of securities can be denoted by XA, XB and XC. The
increase in the investment in security A could be carried out only if he
reduces the proportion of investment either in B or C because it has already
stated that investor tries to earn more income without increasing his
financial commitment. Thus, the changes in different securities will add up
to zero. This is the basic requirement of an arbitrage portfolio. If X indicates
change in proportion,
X A + XB + XC = 0
The factor sensitivity indicates the responsiveness of a securitys return to a
particular factor. The sensitiveness of the securities to any factor is the
weighted average of the sensitivities of the securities, in an arbitrage
portfolio the sensitivities become zero.
bA XA + bB XB + bC XC = 0
the investor holds the A, B and C stocks with the following returns and
sensitivity to changes in the industry production. The total amount invested
is Rs.1, 50,000.
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Stock A
Stock B
Stock C
R
20%
15%
12%
b
.45
1.35
.55
Original weights
.33
.33
.34
XA = .2
XB = .025
XC = -.225
XA + XB + Xc 0
The variance of the new portfolios change is only due to the changes in its
non-factor risk. Hence, the change in the risk factor is negligible. From the
analysis it can be concluded that
1. The return in the arbitrage portfolio is higher than the old portfolio.
2. The arbitrage and old portfolio sensitivity remains the same.
3. The non-factor risk is small enough to be ignored in an arbitrage
portfolio.
EFFECT ON PRICE: to buy stock A and B the investors has to sell
stock C. the buying pressure on stock A and B would lead to increase in
their prices. Conversely selling of stock C will result in fall in the price
of the stock C. with the low price thre would be rise in the expected
return on stock C. for example, if the stock C at price Rs100 per
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Expected return
12.0
13.4
12
bi2
1
3
3
bi2
0.5
0.2
-0.5
i=1
Xi Ri
All the portfolios constructed from portfolios A, B and C lie on the plane
described A, B and C. Assume there exists a portfolio D with an
expected return 14%, bi1 = 2.3 and bi2 = .066. This portfolio can be
compared with the portfolio E having equal portion of A, B and C
portfolios. Every portfolio would have a share of 33%. The portfolio b pj
are
bp1 = 1/3 * 1 +1/3 *3 + 1/3 * 3 = 2.33
bp2 = .5 * 1/3 + .2 1/3 + (-.5 *1/3) = .066
The risk for portfolio E is identical to the risk on portfolio D. the
expected return for portfolio E is
1/3 (12) 1/3 (13.4) + 1/3 (12)
=12.46
Since the portfolio E lies on the plane described above, the return
could be obtained from the equation of the plane.
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R = 10 + 1(2.33) + 2 (.066)
=12.46
The portfolio D and E have the same risk but different returns. In this
juncture, the arbitrageur enters in and buy portfolio D by selling
portfolio E short. Thus buying of portfolio D through the funds
generated from selling E would provide riskless profit with no
investment and no risk. Let us assume that the investor sells Rs 1000
worth of potfolio E and buys Rs 1000 worth of portfolio D. the cash flow
is as shown in the following table.
Portfolio D
Portfolio E
Arbitrage
Portfolio
Initial cash
flow
-Rs 1000
+Rs 1000
0
End of
period
+ 1140.0
- 1124.6
15.4
bi1
Bi2
+2.33
-2.33
0
+.06
-.06
0
The risk is measured along the horizontal axis and the return on the
vertical axis. The A, B and C stocks are considered to be in the same
risk class. The arbitrage pricing line intersects the Y axis on 0, which
represents riskless rate of interest i.e. the interest offered for the
treasury bills. Here, the investments involve zero risk and it is
appealing to the investors who are highly risk averse. i stands for the
slope of arbitrage pricing line. It indicates market price of risk and
measures the risk-return trade off in the security markets. The i is the
sensitivity coefficient or factor beta that shows the sensitivity of the
asset or stock A to there respective risk factor.
THE CONSTANTS OF THE APT EQUATION
The existence of the risk free asset yields a risk free rate of return that
is a constant. The asset does not have sensitivity to the factor for
example, the industrial production.
If bi = 0
Ri = 0 + i0
R i = 0
R i = 0
In other words, 0 is equal to the risk free rate of return. If the single
factor portfolios sensitivity is equal to one i.e. bi = 1 then
Ri = 0 + i1
This can be rewritten as
R i = 0 + i
Ri - 0 = i
Thus, i is the expected excess return over the risk free rate of return
for a portfolio with unit sensitivity to the factor. The excess return is
known as risk premium.
FACTORS AFFECTING THE RETURN
The specification of the factors is carried out by many financial
analysts. Chen, Roll and Ross have taken four macro economic
variables and tested them. According to them the factors are inflation,
the term structure of interest rates, risk premia and industrial
production. Inflation affects the discount rate or the required rate of
return and the size of the future cash flows. The short term inflation is
measured by monthly percentage changes in the consumer price
index. The interest rates on long term payments. The difference
between the return on the high grade bonds and low grade (more
risky) bonds indicates the markets reaction to risk. The industrial
production represents the business cycle changes in the industrial
production have an impact on the expectations and opportunities of
the investor the real value of the cash flow is also affected by it.
The default risk is measured by the difference between the return on long
term government bonds and the return on long term bonds issued by
corporate plus one-half of one per cent. Time premium is measured by return
on long term government bonds minus one month Treasury bill rate one
month ahead. Deflation is measured by expected inflation at the beginning
of the month minus actual inflation during the month. According to them, the
first four factors accounted 25% of the variation in the Standard and Poor
Composite index and all the four co-efficients were significant.
Salomon Brothers identified five factors in their fundamental factor model.
Inflation is the only common factor identified by others. The other factors are
given below.
Rate of interest
Rate of change in all prices
Rate of change in defence spending
All the three sets of factors have some common characteristics. They all
affect the macro economic activities. Inflation and interest rate are identified
as common factors. Thus, the stock price is related to aggregate economic
activity and the discount rate of future cash flow.
APT
Investor do not look at expected
returns and standard deviations
Risk return analysis is not a basis
Investors prefer higher wealth/returns
to lower wealth
APT is based on the return generated
by factor model.
CAPM
Investors look at the expected returns
and accompanying risks measured by
standard deviation
Investors are risk averse and risk
return analysis is necessary
Investors maximize wealth for a given
level of risk
CONCLUSION
an arbitrage portfolio is constructed without any additional financial
commitment
investors indulge in arbitrage, moving the price upwards if securities
are held long and driving down the price of securities if held in short
position, till the elimination of the arbitrage possibilities
The factor sensitivity in arbitrage model indicates the responsiveness
of a securitys return to a particular factor.
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