Pdf the arbitrage pricing theory approach to strategic. Arbitrage pricing theory apt and multifactor models. The theory assumes an assets return is dependent on various macroeconomic, market and securityspecific factors. This chapter presents high theories such as capital asset pricing model, arbitrage pricing theory, and coxingersollross. Capital asset pricing model, arbitrage pricing theory and portfolio management vinod kothari the capital asset pricing model capm is great in terms of its understanding of risk decomposition of risk into securityspecific risk and market risk. Arbitrage pricing theory understanding how apt works. The capital asset pricing model and the arbitrage pricing model. An arbitrage portfolio is a portfolio whose value v t satisfies the following.
Arbitrage pricing theory and the capital asset pricing model. The arbitrage pricing theory a singlefactor version assume a frictionless market with no taxes or transaction costs. Capm is simple and easy to calculate while apt is c. Esuike school of economics, finance and banking university utara, malaysia. The cost of equity is defined as the expected return on an assets common stock in capital markets witmer and zorn, 2007. Further, we explore the arbitrage pricing model with datadriven examples provided using the famamacbeth regressions. The model identifies the market portfolio as the only risk factor the apt makes no assumption about. Asset pricing models, arbitrage pricing theory and. Pdf capital asset pricing model capm and arbitrage pricing theory apt have been a major challenge for economic theorists and. When implemented correctly, it is the practice of being able to take a positive and. Introduction so far, we took the expected return of risky asset as given. Section e of the financial management study guide contains several references to the capital asset pricing model capm. This chapter presents high theories such as capital asset pricing model. Arbitrage pricing theory apt is an alternative to the capital asset pricing model capm for explaining returns of assets or portfolios.
Arbitrage pricing theory and the capital asset pricing. The specific attribute of the market portfolio is that the weight on a stock is the fraction of that stocks market value. The capm is an equilibrium theory of how to price and measure risk, where beta. Capm, factor models and apt corporate finance and incentives lars jul overby.
The arbitrage pricing theory approach to strategic portfolio planning. The journal of portfolio management oct 1991, 18 1 7276. Capm is more reliable as the probability may go wrong. Ross 1976 introduced an alternative to the capm model to explain the returns of financial assets. Furthermore, we exhibit the practical relevance and assumptions of these models. Arbitrage pricing theory university at albany, suny. Apt stands for arbitrage pricing theory that has become very popular among investors because of its ability to make a fair assessment of pricing of different stocks.
It was developed by economist stephen ross in the 1970s. Oct 31, 2010 arbitrage pricing theory based on the law of one price since two otherwise identical assets cannot sell at different prices, equilibrium prices adjust to eliminate all arbitrage opportunities arbitrage opportunity arises if an investor can construct a zero investment portfolio with no risk, but with a positive profit since no investment is. The capm also has the unrealistic assumption that investors can borrow and lend at risk free rate of interest but arbitrage pricing theory does not assume the borrowing and lending at the risk free rate of interest. Capital asset pricing model and arbitrage pricing theory. In finance, arbitrage pricing theory apt is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient. Section f of the study guide for paper f9 contains several references to the capital asset pricing model capm. A major alternative to the capital asset pricing model capm is arbitrage pricing theory apt proposed by ross in 1976. Arbitrage pricing theory according to the arbitrage pricing theory, such arbitrage opportunities cannot exist this implies that the risk premiums are the same for all assets l 1i l 1j for 8i,j l 2i l 2j for 8i,j l ki l kj for 8i,j lars jul overby d of economics uoc 1010 17 24. Arbitrage pricing theory apt apt was conceived by ross 1976 the model starts from a statistical point of view, not a theoretical one like the capm. The arbitrage model was proposed as an alternative to the mean variance capital asset pricing model, introduced by sharpe, lintner, and.
Arbitrage pricing theory the arbitrage pricing theory apt was developed by ross 1976 as a substitute for the capm. Apt considers risk premium basis specified set of factors in addition to the correlation of the price of the asset with expected excess return on the market portfolio. Its formal statement entails the following notation. Arbitrage pricing theory gur huberman and zhenyu wang federal reserve bank of new york staff reports, no. G12 abstract focusing on capital asset returns governed by a factor structure, the arbitrage pricing theory apt is a oneperiod model, in which preclusion of arbitrage over static portfolios. I will start from the efficient market hypothesis, proceed with the markowitz model and then i will analyze the evolutions that led to the capital asset pricing model and eventually the arbitrage pricing theory. The arbitrage pricing theory apt, which allows multiple sources of systematic risks to be taken into account, performs better than the capm, in all the tests considered. Aug 24, 2018 the arbitrage pricing theory, or apt, is a model of pricing that is based on the concept that an asset can have its returns predicted. The capm model assumed that excess returns of capital assets are positively correlated with its degree of.
The market portfolio the market portfolio, m, as any other portfolio, is described by portfolio weights. The first page of the pdf of this article appears above. Difference between capm and apt compare the difference. The capital asset pricing model and the arbitrage pricing theory can both be used to estimate a theoretical rate of return on an asset. The capital asset pricing model is an elegant theory with profound implications for asset pricing and investor behavior. This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the capm. Capm, apt, empirical test, timeseries, regression analysis, beta coefficient, security market line, risk factors, factor loading. Capm relies on the historical data while apt is futuristic. Jun 25, 2019 the arbitrage pricing theory was developed by the economist stephen ross in 1976, as an alternative to the capital asset pricing model capm. In particular, capm only works when we make assumptions about preferences which dont make much sense. This article is the final one in a series of three, and looks at the theory, advantages, and disadvantages of the capm. It is a oneperiod model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. Capital asset pricing andarbitrage pricing theory prof.
Arbitrage pricing theory apt is an asset pricing model which builds upon the capital asset pricing model capm but defines expected return on a security as a linear sum of several systematic risk premia instead of a single market risk premium. Jun 18, 2019 the capital asset pricing model and the arbitrage pricing theory can both be used to estimate a theoretical rate of return on an asset. Apt considers risk premium basis specified set of factors in addition to the correlation of the price of asset with expected excess return on market portfolio. Apr 15, 1997 in the capitalassetpricing model capm. Comparing the arbitrage pricing theory and the capital. Arbitrage pricing theory apt the fundamental foundation for the arbitrage pricing theory apt is the law of one price, which states that 2 identical items will sell for the same price, for if they do not, then a riskless profit could be made by arbitragebuying the item in the cheaper market then selling it in the more expensive market. Pdf the capital asset pricing model and the arbitrage. Arbitrage pricing theory as opposed to capm is a multifactor model suggesting that expected return of an asset cannot be measured accurately by taking into account only one factor, i.
The arbitrage pricing theory operates with a pricing model that factors in many sources of risk and uncertainty. The arbitrage approach states that the expected return of an asset is not determined by one single variable market mean and variance but it is determined by various macroeconomic factors and the change sensitivity of each factor 1. The capm makes assumptions about investor preferences more return is preferred to less, and risk must be rewarded, about investors behaviour risk is variance of the portfolio, and mean and variance of returns are the normal investors key considerations and about the world investors forecasts are homogeneous and. Capm is a wellknown and accepted single factor model, after four decades.
The capital asset pricing model capm and the arbitrage pricing theory apt have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. The capitalassetpricing model and arbitrage pricing theory. The first article in the series introduced the capm and its components, showed how the model could be used to estimate the cost of. A big difference between capm and the arbitrage pricing theory is that apt does not spell out specific risk factors or even the number of factors involved. Assumptions individual investors are price takers singleperiod investment horizon investments are limited to traded financial assets no taxes, and transaction costs 3. The capm lets investors quantify the expected return on investment given the risk, riskfree rate of return, expected market return, and the beta of an asset or portfolio. Unlike the welldocumented contribution of these models to understanding the relationship between return and risk and valuing assets on. The capital asset pricing model and arbitrage pricing theory. The arbitrage pricing theory apt proposed by ross 1976, 1977, has come as an alternative to capm measure of riskreturn. Capm requires that in equilibrium total asset holdings of all. We examine the tradeoff between risk and return in real world applications founded on the premises behind the capm.
The capm lets investors quantify the expected return on investment given the risk, riskfree rate of return, expected market return. Comparing the arbitrage pricing theory and the capital asset. Apt is an alternative to the capital asset pricing model capm. The modelderived rate of return will then be used to price the asset. The first article, published in the january 2008 issue of student. Espen eckbo 2011 basic assumptions the capm assumes homogeneous expectations and meanexpectations and meanvariance variance preferences. Portfolio theory analyzes investors asset demand given asset returns. Ross arbitrage pricing theory apt proposes a multifactor structure in which the return of a given financial asset is a function of a freerisk rate and a series of macroeconomic variables. Subsequently, capital asset pricing model capm has been developed by sharpe 1964, linter 1965 and mossin 1966. Arbitrage pricing theory, often referred to as apt, was developed in the 1970s by stephen ross. Factor pricing slide 1223 capm esting fama french 1992 using newer data slope of sml b is not significant adding size and bm. Apt often viewed as a substitute to the capital asset pricing model capm. Pdf the capital asset pricing model and the arbitrage pricing.
The capm is a model for determining the required rate of return on an asset, taking into the risk of the asset. Mar 01, 2017 a comparative study of the arbitrage pricing theory apt and the capital asset pricing model capm was done in the indian scenario on the lines of the methodology proposed by chen 1983. May 09, 2019 the arbitrage pricing theory is an alternative to the capm that uses fewer assumptions and can be harder to implement than the capm. A factor analysis maximum likelihood method was done on the daily returns data of selected scrips from the mumbai stock exchange bse to derive the factors. The capital asset pricing model capm provides a simple, yet elegant framework. Reconciling the arbitrage pricing theory apt and the capital 17 20532199 print, 20532202online asset pricing model capm institutional and theoretical framework ejuvbekpokpo stephen akpo, sallahuddin hassan and benjamin u. Capital asset pricing model, arbitrage pricing theory and. An empirical investigation of the apt in a frontier stock. Capital asset pricing model capm and arbitrage pricing theory apt have been a major challenge for economic theorists and practitioners for decades.
Arbitrage pricing theory apt is an alternate version of the capital asset pricing model capm. However, the use of apt in determining the factors which influences expected returns is too general. While capm uses the expected market return in its formula, apt uses the expected rate of return and the risk premium of a number of macroeconomic factors. May 27, 2011 capm and apt are two such valuation tools. The arbitrage pricing theory apt starts by assuming that actual returns are generated by a number of systematic factors a securitys risk is measured by its sensitivity to each of these factors from this we can derive an equilibrium relationship between expected return and risk the apt and capm may have a similar. Both of them are based on the efficient market hypothesis, and are part of the modern portfolio theory. Pdf capital asset pricing model versus arbitrage pricing theory. Capital asset pricing model capm indicates what should be expected or required rates of return rrr on the risky assets which is equal to cost of equity, discounting rate used to. It is considered to be an alternative to the capital asset pricing model as a method to explain the returns of portfolios or assets. Capm considers only single factor while apt considers multifactors. The capm, suggests that only nondiversifiable market risk influences expected security returns. The arbitrage model was proposed as an alternative to the mean variance capital asset pricing model, introduced by sharpe, lintner, and treynor, that has become the.
Arbitrage pricing theory apt has developed into one of the modern financial theory. Arbitrage pricing theory apt is an alternate version of capital asset pricing capm model. Classical asset pricing models, such as capm and apt arbitrage pricing 1. This theory, like capm, provides investors with an estimated required rate of return on risky securities. To do so, the relationship between the asset and its common risk factors must be analyzed. Introduction to the capital asset pricing model capm duration. Arbitrage pricing theory the journal of portfolio management. In the first section i will present the main theories and the relative empirical tests developed on asset pricing in the last 60 years. While the capm is a singlefactor model, apt allows for multifactor models to describe risk and return relationship of a stock. The arbitrage pricing theory apt was developed primarily by ross 1976a, 1976b. Test of arbitrage pricing theory on the tehran stock exchange. Did the manager exhibit positive performance ability according to the capm. January 1990 june 2001 is weak, and the capital asset pricing model capm has poor overall explanatory power.
Pdf capital asset pricing model versus arbitrage pricing. Arbitrage pricing theory assumptions explained hrf. The arbitrage theory of capital asset pricing was developed by ross 9, 10, 1 l as an alternative to the meanvariance capital asset pricing model capm, whose main conclusion is that the market portfolio is mean variance efficient. The capm assumes that there are no taxes to be considered whereas the arbitrage pricing theory does not believe in it. The arbitrage pricing theory is an alternative to the capm that uses fewer assumptions and can be harder to implement than the capm. The two major theories on equilibrium pricing of securities are capital asset pricing model capm extended by sharp 1964, lintner 1965, mossin 1966 and black, jensen and scholes 1972 and the arbitrage pricing theory apt.
Comparing the arbitrage pricing theory and the capital asset pricing model there are inherent risks in holding any asset, and the capital asset pricing model capm and the arbitrage pricing model apm are both ways of calculating the cost of an asset and the rate of return which can be expected based on the risk level inherent in the asset. Theory, are discussed as special cases of modern asset pricing theory using stochastic discount factor. Hedge fund xyz had an average annualized return of 12. This lecture covers the basics of the capital asset pricing model and looks into its derivation. The capital asset pricing model and the arbitrage pricing theory. Unlike the capital asset pricing model capm which only takes into account the single factor of the risk level of the overall market, the apt model looks at several macroeconomic factors that, according to the theory, determine the. Arbitrage pricing theory apt is a wellknown method of estimating the price of an asset. The big difference between apt and capm is that capm only looks at the asset in comparison to market changes, whereas apt looks at multiple factors. While both are useful, many investors prefer to use the capm, a. The capital asset pricing model and the arbitrage pricing. Jun 16, 2014 arbitrage pricing theory and multifactor models of risk and return frm p1.
Analysis and accuracy level comparison between capital. But how useful is the model given the idealized world that underlies its derivation. The purpose of this paper is to examine rigorously the arbitrage model of capital asset pricing developed in ross, 141. Unlike the capm, which assume markets are perfectly. Arbitrage pricing theory apt was introduced by stephen. Before we try to find out the differences between apt and capm, let us take a closer look at the two theories. Arbitrage pricing theory stephen kinsella the arbitrage pricing theory, or apt, was developed to shore up some of the deficiences of capm we discussed in at the end of the last lecture. This theory, like capm provides investors with estimated required rate of return on risky securities. Markets expected return is used in the capm formula. The capitalassetpricing model and arbitrage pricing theory pnas. The basic principle of the apt is that the payoff from each asset can be described as a weighted average of all assets in a portfolio. Financial economics arbitrage pricing theory theorem 2 arbitrage pricing theory in the exact factor model, the law of one price holds if only if the mean excess return is a linear combination of the beta coef. A comparative study of the arbitrage pricing theory apt and the capital asset pricing model capm was done in the indian scenario on the lines of the methodology proposed by chen 1983.
1486 272 407 1669 835 1363 25 1090 1019 1139 1382 558 630 171 452 274 392 393 760 806 1109 1085 277 1571 613 1602 1126 600 1429 1064 447 1507 1288 1302 515 1009 254 1044 202 411 32 1487 1215 569 1059 782 1014