ARBITRAGE PRICING THEORY

BY: Rashmi ranjan

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Arbitrage Pricing Theory
Arbitrage Pricing Theory (APT) is a valuation
model alternative to CAPM.
The expected return on an asset is a function of
many factors and the sensitivity of the stock to
these factors
Arbitrage arises when investors take
opportunities of miss priced shares with equal
risks exposures.
In efficient markets, profitable arbitrage
opportunities will quickly disappear.
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Arbitrage Pricing Theory

The arbitrage pricing theory (APT) is

based on the law of one price, which
states that two stock with the same risk
characteristics must sell at the same
price.

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Arbitrage Pricing Theory

The Arbitrage Pricing Theory leaves it up to the

investor, or analyst, to identify each of the factors for
a particular stock. 
So the real challenge for the investor is to identify
three things:
Each of the factors affecting a particular stock
The expected returns for each of these factors
The sensitivity of the stock to each of these factors

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COMMON FACTOR DRIVING ASSET RETURN

Common factors driving asset returns may include

GNP, interest rates, inflation, etc.
FOR EXAMPLE;
 Let ˜ Fint be the news on interest rates. Before a board meeting of the
RBI, the market expects the RBI not to change the interest rate. After
the meeting,SBI announces that
 • There is no change in interest rate — “no news”:
 F int. = 0.
 There is a 1/4% increase in interest rate — “positive surprise”:

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Factor Models: Announcements,
Surprises, and Expected Returns
 The return on any security consists of two parts.
 First the expected returns
 Second is the unexpected or risky returns.

R  R U
where
R is the expected part of the return
U is the unexpected part of the return

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Factor Models: Announcements, Surprises,
and Expected Returns
 Any announcement can be broken down into
two parts, the anticipated or expected part and
the surprise or innovation:
 Announcement = Expected part + Surprise.
 The expected part of any announcement is part
of the information the market uses to form the
expectation, R of the return on the stock.
 The surprise is the news that influences
the unanticipated return on the stock, U.
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Risk: Systematic and Unsystematic
 A systematic risk is any risk that affects a large number
of assets, each to a greater or lesser degree.
 An unsystematic risk is a risk that specifically affects a
single asset or small group of assets.
 Unsystematic risk can be diversified away.
 Examples of systematic risk include uncertainty about
general economic conditions, such as GNP, interest
rates or inflation.
 On the other hand, announcements specific to a
company, such as a gold mining company striking gold,
are examples of unsystematic risk.

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Risk: Systematic and Unsystematic
We can break down the risk, U, of holding a stock into two
components: systematic risk and unsystematic risk:

Total risk; U R  R U
becomes
 R  R m ε
where
Nonsystematic Risk; 
m is the systematic risk
Systematic Risk; m ε is the unsystematic risk

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Systematic Risk and Betas
 The beta coefficient, , tells us the response of the
stock’s return to a systematic risk.
 In the CAPM,  measured the responsiveness of a
security’s return to a specific risk factor, the return
on the market portfolio.
Cov ( Ri , RM )
i 
2 ( RM )
 We shall now consider many types of systematic
risk.

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Systematic Risk and Betas
 For example, suppose we have identified three systematic risks on
which we want to focus:
1. Inflation
2. GDP growth
3. The dollar-euro
R  R m ε
spot exchange R  R  βI FI  βGDP FGDP  βS FS  ε
rate, S($,€)
 Our model is: βI is the inflation beta
βGDP is the GDP beta
βS is the spot exchange rate beta
ε is the unsystematic risk
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Systematic Risk and Betas:
Example
R  R  βI FI  βGDP FGDP  βS FS  ε
 Suppose we have made the following estimates:
1. I = -2.30
2. GDP = 1.50
3. S = 0.50.
 Finally, the firm was able to attract a “superstar” CEO
and this unanticipated development contributes 1% to
the return.
ε  1%

R  R  2.30  FI 1.50  FGDP  0.50  FS 1%

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Systematic Risk and Betas:
Example
R  R  2.30  FI 1.50  FGDP  0.50  FS 1%
We must decide what surprises took place in the
systematic factors.
If it was the case that the inflation rate was expected to be
by 3%, but in fact was 8% during the time period, then
FI = Surprise in the inflation rate
= actual – expected
= 8% – 3%
= 5%

R  R  2.30 5% 1.50  FGDP  0.50  FS 1%

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Systematic Risk and Betas:
Example
R  R  2.30 5% 1.50  FGDP  0.50  FS 1%
If it was the case that the rate of GDP growth was
expected to be 4%, but in fact was 1%, then
FGDP = Surprise in the rate of GDP growth
= actual – expected
= 1% – 4%
= – 3%

R  R  2.30 5% 1.50 ( 3%)  0.50  FS 1%

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Systematic Risk and Betas:
Example
R  R  2.30 5% 1.50 ( 3%)  0.50  FS 1%
If it was the case that dollar-euro spot exchange rate, S($,
€), was expected to increase by 10%, but in fact
remained stable during the time period, then
FS = Surprise in the exchange rate
= actual – expected
= 0% – 10%
= – 10%

R  R  2.30 5% 1.50 ( 3%)  0.50 ( 10%) 1%

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Systematic Risk and Betas:
Example

R  R  2.30 5% 1.50 ( 3%)  0.50  FS 1%

Finally, if it was the case that the expected return

on the stock was 8%, then

R  8%

R  8%  2.30  5%  1.50  (3%)  0.50  (10%)  1%

R  12%
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Relationship Between the Return on the
Common Factor & Excess Return

Excess
return βA 1.5 β B  1.0
Different
securities will
βC  0.50 have different
betas

The return on the factor F

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Portfolios and Diversification
 We know that the portfolio return is the weighted average of the
returns on the individual assets in the portfolio:

RP  X1 R1  X 2 R2    Xi Ri    X N RN

Ri  Ri  βi F  εi
RP  X1 ( R1  β1 F  ε1 )  X2 ( R2  β2 F  ε2 ) 
  X N ( RN  βN F  εN )

RP  X1 R1  X1 β1 F  X1 ε1  X2 R2  X 2 β2 F  X 2 ε2 
  X N RN  X N βN F  X N εN
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Portfolios and Diversification
The return on any portfolio is determined by three sets of
parameters:
1. The weighed average of expected returns.
2. The weighted average of the betas times the factor.
3. The weighted average of the unsystematic risks.
RP  X1 R1  X2 R2    X N RN
 ( X1 β1  X2 β2    X N βN ) F
 X1 ε1  X2 ε2    X N εN
In a large portfolio, the third row of this equation disappears as the
unsystematic risk is diversified away.
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Betas and Expected Returns

RP  X1 R1    X N RN  ( X1 β1    X N βN ) F

RP βP
Recall that and
RP  X1 R1    X N RN βP  X1 β1    X N βN
The return on a diversified portfolio is the sum of the
expected return plus the sensitivity of the portfolio to
the factor.

RP  RP  βP F
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Relationship Between  & Expected Return

 If shareholders are ignoring

unsystematic risk, only the systematic
risk of a stock can be related to its
expected return.
RP  RP  βP F

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Strength and Weaknesses of APT
 1.The model gives a reasonable description of return and
risk.
 2. No need to measure market portfolio correctly.
 3. Model itself does not say what the right factors are.
 4. Factors can change over time.
 5. Estimating multi-factor models requires more data

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Difference between APT & CAPM
 APT is based on the factor model of returns and the
“approximate arbitrage” argument.

 CAPM’s are based on investors’ portfolio demand and

equilibrium argument.

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Summary and Conclusions
 The APT assumes that stock returns are generated according to
factor models such as:

R  R  βI FI  βGDP FGDP  βS FS  ε
 As securities are added to the portfolio, the unsystematic risks of the
individual securities offset each other. A fully diversified portfolio has
no unsystematic risk.
 The CAPM can be viewed as a special case of the APT.

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