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By Elvin Mirzayev, CFA, FRM | Updated April 9, 2018 — 9:00 AM EDT
Arbitrage pricing theory (APT) is an alternative to the capital asset pricing model
(CAPM) for explaining returns of assets or portfolios. It was developed by
economist Stephen Ross in the 1970s. Over the years, arbitrage pricing theory has grown
in popularity for its relatively simpler assumptions. However, arbitrage pricing theory is a
lot more difficult to apply in practice because it requires a lot of data and complex
statistical analysis.
Let's see what arbitrage pricing theory is and how we can put it to practice.
What Is APT?
APT is a multi-factor technical model based on the relationship between a financial
asset's expected return and its risk. The model is designed to capture the sensitivity of the
asset's returns to changes in certain macroeconomic variables. Investors and financial
analysts can use these results to help price securities.
Inherent to the arbitrage pricing theory is the belief that mispriced securities can represent
short-term, risk-free profit opportunities. APT differs from the more
conventional CAPM, which uses only a single factor. Like CAPM, however, the APT
assumes that a factor model can effectively describe the correlation between risk and
return.
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No arbitrage opportunity exists among well-diversified portfolios. If any arbitrage
opportunities do exist, they will be exploited away by investors. (This how the
theory got its name.)
For a well-diversified portfolio, a basic formula describing arbitrage pricing theory can
be written as the following:
Rf is the return if the asset did not have exposure to any factors, that is to say all ßn = 0.
Unlike in the capital asset pricing model, the arbitrage pricing theory does not specify the
factors. However, according to the research of Stephen Ross and Richard Roll, the most
important factors are the following:
Change in inflation
Change in the level of industrial production
Shifts in risk premiums
Change in the shape of the term structure of interest rates
According to researchers Ross and Roll, if no surprise happens in the change of the above
factors, the actual return will be equal to the expected return. However, in case of
unanticipated changes to the factors, the actual return will be defined as follows:
2
Note that f'n is the unanticipated change in the factor or surprise factor, e is the residual
part of actual return.
(For more on the capital asset pricing model, read The Advantages and Disadvantages of
the CAPM Model.)
For the purpose of illustrating the technique of estimating ßn (sensitivity to the factor
n) and fn (the nth factor price), let's take the S&P 500 Total Return Index and the
NASDAQ Composite Total Return Index as proxies for well-diversified portfolios for
which we wish to find ßn and fn. For simplicity, we'll assume that we know Rf (the risk
free return) is 2 percent. We'll also assume that the annual expected return of the
portfolios are 7 percent for the S&P 500 Total Return Index and 9 percent for the
NASDAQ Composite Total Return Index.
We ran a regression on historical quarterly data of each index against quarterly real GDP
growth rates and quarterly T-bond yield changes. Note that because these calculations are
for illustrative purposes only, we will skip the technical sides of regression analysis.
3
Here are the results:
Regression results tell us that both portfolios have much higher sensitivities to GDP
growth rates (which is logical because GDP growth is usually reflected in the equity
market change) and very tiny sensitivities to T-bond yield change (this too is logical
because stocks are less sensitive to yield changes than bonds).
Now that we have obtained beta factors, we can estimate factor prices by solving the
following set of equations:
7% = 2% + 3.45*f1+0.033*f2
9% = 2% + 4.74*f1+0.098*f2
Therefore, a general ex-ante arbitrage pricing theory equation for any i portfolio will be
as follows:
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Taking Advantage of Arbitrage Opportunities
The idea behind a no-arbitrage condition is that if there is a mispriced security in the
market, investors can always construct a portfolio with factor sensitivities similar to those
of mispriced securities and exploit the arbitrage opportunity.
For example, suppose that apart from our index portfolios there is an ABC Portfolio with
the respective data provided in the following table:
Expected
Portfolios ß1 ß2
Return
S&P 500 Total Return Index 7% 3.45 0.033
NASDAQ Composite Total Return Index 9% 4.74 0.098
ABC Portfolio (or Arbitrage Portfolio) 8% 3.837 0.0525
Combined Index Portfolio =
7.6% 3.837 0.0525
0.7*S&P500+0.3*NASDAQ
We can construct a portfolio from the first two index portfolios (with an S&P 500 Total
Return Index weight of 70 percent and NASDAQ Composite Total Return Index weight
of 30 percent) with similar factor sensitivities as the ABC Portfolio as shown in the last
raw of the table. Let's call this the Combined Index Portfolio. The Combined Index
Portfolio has the same betas to the systematic factors as the ABC Portfolio but a lower
expected return.
This implies that the ABC portfolio is undervalued. We will then short the Combined
Index Portfolio and with those proceeds purchase shares of the ABC Portfolio, which is
also called the arbitrage portfolio (because it exploits the arbitrage opportunity). As all
investors would sell an overvalued and buy an undervalued portfolio, this would drive
away any arbitrage profit. This is why the theory is called arbitrage pricing theory.
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The Bottom Line
Arbitrage pricing theory, as an alternative model to the capital asset pricing model, tries
to explain asset or portfolio returns with systematic factors and asset/portfolio
sensitivities to such factors. The theory estimates the expected returns of a well-
diversified portfolios with the underlying assumption that portfolios are well-diversified
and any discrepancy from the equilibrium price in the market would be
instantaneously driven away by investors. Any difference between actual return and
expected return is explained by factor surprises (differences between expected and actual
values of factors).
The drawback of arbitrage pricing theory is that it does not specify the systematic factors,
but analysts can find these by regressing historical portfolio returns against factors such
as real GDP growth rates, inflation changes, term structure changes, risk premium
changes and so on. Regression equations make it possible to assess which systematic
factors explain portfolio returns and which do not.
Read more: Arbitrage Pricing Theory: It's Not Just Fancy Math | Investopedia
https://www.investopedia.com/articles/active-trading/082415/arbitrage-pricing-theory-its-not-
just-fancy-math.asp#ixzz5PXKCwXed
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