Arbitrage Pricing Theory Against Capital Asset Pricing Model

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In the modern financial theory, development of financial equilibrium asset pricing models has been the most important field of research. These models are widely experimented for developed markets. Explanatory factor analysis approach and Pre-specified macro-economic approach indicates two factors governing stock return which also identifies these two factors as the anticipated and unanticipated inflation and market index and dividend yield. The applications of financial equilibrium models have been very thoroughly investigated. These applications are widely used for several purposes such as predicting common stock systematic risk and defining the opportunity cost of capital. Here, let’s looks at the overview from the CAPM to the APT which we will discuss further. Arbitrage Pricing Theory (APT), founded upon the work of Ross (1976,1977), purpose to analyze the equilibrium relationship between assets’ risk and expected return just as the CAPM does. The two major CAPM assumptions of perfectly competitive and efficient markets and homogeneous expectations are remained. Moreover, in line with the CAPM, the APT assumes that portfolios are sufficiently varied, so that the contribution to the total portfolio risk of assets’ unique (unsystematic) risk is about zero. The APT’s two main differences from the CAPM are: (a) The explicit modeling of several factors affecting assets’ actual and expected returns, different to the CAPM which focus on the market portfolio only. (b) The fact that the equilibrium relationship is only closely related and is derived based on a no-arbitrage assumption. The two are interrelated, as market equilibrium in the CAPM rests on the observability and efficiency of the market portfolio.

Background Studies

The Arbitrage Pricing Theory (APT) was developed primarily by Stephen Ross (1976a, 1976b). It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. In other word, it is an asset pricing model based on the idea that an asset’s returns can be predicted using the relationship between that same asset and many common risk factors. This theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables. (Arbitrage pricing theory (APT) (n.d.)) Macro-economic variables are: Changes in GNP growth Change in Treasure bill yield (proxy for expected inflation) Changes in yield spread between Treasure bonds and Treasury bills Changes in default premium on corporate bonds Changes in prices level of oil Ross argues that if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the factor loadings. (The factor loadings, or betas, are proportional to the returns’ covariances with the factors.) This intuition is shows that the linear pricing relation is a necessary condition for equilibrium in a market where agents maximize certain types of utility. A linear relation between the expected returns and the betas is tantamount to an identification of the stochastic discount factor (SDF). The use of Factor Analysis (FA) developed by Spearman and Hotelling at the beginning of the last century as a potential tool for the extraction of the K common factors from a sample of returns.

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