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| 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 macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific [[beta coefficient]]. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price [[Discounting|discounted]] at the rate implied by the model. If the price diverges, [[arbitrage]] should bring it back into line.
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| The [[theory]] was proposed by the [[economist]] [[Stephen Ross (economist)|Stephen Ross]] in 1976.
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| ==The APT model==
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| Risky asset returns are said to follow a ''factor intensity structure'' if they can be expressed as:
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| :<math>r_j = a_j + b_{j1}F_1 + b_{j2}F_2 + \cdots + b_{jn}F_n + \epsilon_j</math>
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| :where
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| :* <math>a_j</math> is a constant for asset <math>j</math>
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| :* <math>F_k</math> is a systematic factor
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| :* <math>b_{jk}</math> is the sensitivity of the <math>j</math>th asset to factor <math>k</math>, also called factor loading,
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| :* and <math>\epsilon_j</math> is the risky asset's idiosyncratic random shock with mean zero.
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| Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.
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| The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:
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| :<math>E\left(r_j\right) = r_f + b_{j1}RP_1 + b_{j2}RP_2 + \cdots + b_{jn}RP_n</math>
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| :where
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| :* <math>RP_k</math> is the [[risk premium]] of the factor,
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| :* <math>r_f</math> is the [[risk-free rate]],
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| That is, the expected return of an asset ''j'' is a [[linear]] function of the asset's sensitivities to the ''n'' factors.
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| Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be [[perfect competition]] in the market, and the total number of factors may never surpass the total number of assets (in order to avoid the problem of [[matrix singularity]]),
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| ==Arbitrage and the APT==
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| [[Arbitrage]] is the practice of taking positive expected return from overvalued or undervalued securities in the inefficient market without any incremental risk and zero additional investments.
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| ===Arbitrage in expectations===
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| The [[capital asset pricing model]] and its extensions are based on specific assumptions
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| on investors’ asset demand. For example:
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| * Investors care only about mean return and variance.
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| * Investors hold only traded assets.
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| ===Arbitrage mechanics===
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| In the APT context, arbitrage consists of trading in two assets – with at least one being mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap.
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| Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model. The asset price today should equal the sum of all future cash flows [[wikt:Special:Search/discount|discounted]] at the APT rate, where the expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor is represented by a factor-specific [[beta coefficient]].
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| A correctly priced asset here may be in fact a ''synthetic'' asset - a ''portfolio'' consisting of other correctly priced assets. This portfolio has the same exposure to each of the macroeconomic factors as the mispriced asset. The arbitrageur creates the portfolio by identifying x correctly priced assets (one per factor plus one) and then weighting the assets such that portfolio beta per factor is the same as for the mispriced asset.
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| When the investor is [[long (finance)|long]] the asset and [[Short (finance)|short]] the portfolio (or vice versa) he has created a position which has a positive expected return (the difference between asset return and portfolio return) and which has a net-zero exposure to any macroeconomic factor and is therefore risk free (other than for firm specific risk). The arbitrageur is thus in a position to make a risk-free profit:
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| <blockquote style="background: 1; border: 1px solid black; padding: 1em;">
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| Where today's price is too low:
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| :The implication is that at the end of the period the ''portfolio'' would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at ''more'' than this rate. The arbitrageur could therefore:
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| ::Today:
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| :::1 [[short selling|short sell]] the ''portfolio''
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| :::2 buy the mispriced asset with the proceeds.
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| ::At the end of the period:
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| :::1 sell the mispriced asset
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| :::2 use the proceeds to buy back the ''portfolio''
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| :::3 pocket the difference.
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| </blockquote> | |
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| <blockquote style="background: 1; border: 1px solid black; padding: 1em;"> | |
| Where today's price is too high:
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| :The implication is that at the end of the period the ''portfolio'' would have appreciated at the rate implied by the APT, whereas the mispriced asset would have appreciated at ''less'' than this rate. The arbitrageur could therefore:
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| :: Today:
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| :::1 [[short selling|short sell]] the mispriced asset
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| :::2 buy the ''portfolio'' with the proceeds.
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| :: At the end of the period:
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| :::1 sell the ''portfolio''
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| :::2 use the proceeds to buy back the mispriced asset
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| :::3 pocket the difference.
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| </blockquote>
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| ==Relationship with the capital asset pricing model (CAPM)==
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| The APT along with the [[capital asset pricing model]] (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions. It allows for an explanatory (as opposed to statistical) model of asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM can be considered a "special case" of the APT in that the [[Modern portfolio theory#Securities Market Line|securities market line]] represents a single-factor model of the asset price, where beta is exposed to changes in value of the market.
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| Additionally, the APT can be seen as a "supply-side" model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause structural changes in assets' expected returns, or in the case of stocks, in firms' profitabilities.
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| On the other side, the [[capital asset pricing model]] is considered a "demand side" model. Its results, although similar to those of the APT, arise from a maximization problem of each investor's utility function, and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets).
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| ==Using the APT==
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| ===Identifying the factors===
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| As with the CAPM, the factor-specific betas are found via a [[linear regression]] of historical security returns on the factor in question. Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors - the number and nature of these factors is likely to change over time and between economies. As a result, this issue is essentially [[Empirical evidence|empirical]] in nature. Several ''[[A priori and a posteriori|a priori]]'' guidelines as to the characteristics required of potential factors are, however, suggested:
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| # their impact on asset prices manifests in their ''unexpected'' movements
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| # they should represent ''undiversifiable'' influences (these are, clearly, more likely to be macroeconomic rather than firm-specific in nature)
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| # timely and accurate information on these variables is required
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| # the relationship should be theoretically justifiable on economic grounds
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| Chen, [[Richard Roll|Roll]] and [[Stephen Ross (economist)|Ross]] (1986) identified the following macro-economic factors as significant in explaining security returns:
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| *surprises in [[inflation]];
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| *surprises in [[GNP]] as indicated by an industrial production index;
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| *surprises in investor confidence due to changes in default premium in corporate bonds;
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| *surprise shifts in the [[yield curve]].
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| As a practical matter, indices or spot or futures market prices may be used in place of macro-economic factors, which are reported at low frequency (e.g. monthly) and often with significant estimation errors. Market indices are sometimes derived by means of [[factor analysis]]. More direct "indices" that might be used are:
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| *short term interest rates;
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| *the difference in long-term and short-term interest rates;
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| *a diversified stock index such as the [[S&P 500]] or [[NYSE Composite Index]];
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| *oil prices
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| *gold or other precious metal prices
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| *Currency [[exchange rate]]s
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| ===APT and asset management===
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| The linear factor model structure of the APT is used as the basis for many of the commercial risk systems employed by asset managers.
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| ==See also==
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| *[[Beta coefficient]]
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| *[[Capital asset pricing model]]
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| *[[Cost of capital]]
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| *[[Earnings response coefficient]]
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| *[[Efficient-market hypothesis]]
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| *[[Fundamental theorem of arbitrage-free pricing]]
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| *[[Investment theory]]
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| *[[Roll's critique]]
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| *[[Rational pricing]]
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| *[[Modern portfolio theory]]
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| *[[Post-modern portfolio theory]]
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| *[[Value investing]]
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| ==References==
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| *{{cite journal |last=Burmeister |first=Edwin |authorlink= |coauthors=Wall, Kent D. |year=1986 |month= |title=The arbitrage pricing theory and macroeconomic factor measures |journal=Financial Review |volume=21 |issue=1 |pages=1–20 |doi=10.1111/j.1540-6288.1986.tb01103.x |url= |accessdate= }}
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| *{{cite journal |last=Chen |first=N. F. |authorlink= |coauthors=Ingersoll, E. |year=1983 |month= |title=Exact Pricing in Linear Factor Models with Finitely Many Assets: A Note |journal=Journal of Finance |volume=38 |issue=3 |pages=985–988 |doi=10.2307/2328092 |jstor= 2328092}}
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| *{{cite journal |last=Roll |first=Richard |authorlink= |coauthors=Ross, Stephen |year=1980 |month= |title=An empirical investigation of the arbitrage pricing theory |journal=Journal of Finance |volume=35 |issue= 5|pages=1073–1103 |doi= 10.2307/2327087|jstor= 2327087}}
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| *{{cite journal |last=Ross |first=Stephen |authorlink= |coauthors= |year=1976 |month= |title=The arbitrage theory of capital asset pricing |journal=Journal of Economic Theory |volume=13 |issue=3 |pages=341–360 |url= |accessdate= |doi=10.1016/0022-0531(76)90046-6 }}
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| *{{cite journal |last=Chen |first=Nai-Fu |coauthors=[[Richard Roll|Roll]], Richard; Ross, Stephen |year=1986 |month= |title=Economic Forces and the Stock Market |journal=Journal of Business |volume=59 |issue=3 |pages=383–403 |url=http://dipeco.economia.unimib.it/finarm/2004/material/tirelli/dyn_econom/chenrollross.pdf |accessdate=2008-12-01 |doi=10.1086/296344 }}
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| ==External links==
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| *[http://viking.som.yale.edu/will/finman540/classnotes/class6.html The Arbitrage Pricing Theory] Prof. William N. Goetzmann, [[Yale School of Management]]
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| *[http://www.cfapubs.org/doi/pdf/10.2469/faj.v51.n1.1868 The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning] ([[portable document format|PDF]]), Richard Roll and [[Stephen Ross (economist)|Stephen A. Ross]]
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| *[http://www-personal.umich.edu/~shumway/courses.dir/ba855.dir/apt.pdf The APT], Prof. Tyler Shumway, [[University of Michigan Business School]]
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| *[http://www.iassa.co.za/images/file/indexmain.htm The arbitrage pricing theory] [[Investment Analysts Society of South Africa]]
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| *[http://www.kellogg.northwestern.edu/faculty/korajczy/htm/aptlist.htm References on the Arbitrage Pricing Theory], Prof. Robert A. Korajczyk, [[Kellogg School of Management]]
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| *[http://web.mit.edu/15.407/file/Ch12.pdf Chapter 12: Arbitrage Pricing Theory (APT)], Prof. Jiang Wang, [[Massachusetts Institute of Technology]].
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| {{Stock market}}
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| [[Category:Finance theories]]
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| [[Category:Mathematical finance]]
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| [[Category:Portfolio theories]]
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| [[Category:Pricing]]
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| [[Category:Financial economics]]
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