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ARBITRAGE PRICING THEORY

Welcome to Unitedworld

FACTOR MODEL AND

ARBITRAGE PRICING THEORY

RETURN FROM SHARES ARE NOT

BASED ON SINGLE FACTOR S Ross

S Ross propounded the concept that security returns are

not based on one single factor (index) of the market;

instead, each security is linked with multiple factors and

returns get influenced by these factors. The theory given

by S Ross is called arbitrage pricing theory and multiple

factor theory. APT believes that the return generating

f ti l it / tf li d t tprocess of a particular security/ portfolio does not get

influenced by its association with the market portfolio

(index). Rather it is influenced by several logical factors

Gross Domestic product (GDP), National Income,

Personal Disposable Income, Inflation Interest Rate,

Consumer Price Index, Wholesale Price Index, Bank Rate,

Foreign Exchange Rate etc. therefore, one must consider

several factors instead of only the index of market to

arrive at investment decision. Similarly, disequilibrium in

share prices can lead to the process of arbitrage.

RETURN FROM SHARES ARE NOT

BASED ON SINGLE FACTOR S Ross

S Ross propounded the concept that security returns are

not based on one single factor (index) of the market;

instead, each security is linked with multiple factors and

returns get influenced by these factors. The theory given

by S Ross is called arbitrage pricing theory and multiple

factor theory. APT believes that the return generating

f ti l it / tf li d t tprocess of a particular security/ portfolio does not get

influenced by its association with the market portfolio

(index). Rather it is influenced by several logical factors

Gross Domestic product (GDP), National Income,

Personal Disposable Income, Inflation Interest Rate,

Consumer Price Index, Wholesale Price Index, Bank Rate,

Foreign Exchange Rate etc. therefore, one must consider

several factors instead of only the index of market to

arrive at investment decision. Similarly, disequilibrium in

share prices can lead to the process of arbitrage.

CONCEPT OF ARBITRAGE PRICING

THEORY (APT)

This model has been developed by S Ross, using a notion that

security returns are not based on one single factor (index) of the

market; instead each security is linked with multiple factors and

returns get influenced by these factors. APT believes that the return

generating process of a particular security/portfolio does not get

influenced by its association with the market portfolio; rather it is

influenced by several logical factors gross domestic product

(GDP), national income, personal disposable income, inflation,

interest rate, consumer price index, wholesale price index, bank

rate, foreign exchange rate, etc. APT also emphasizes the

fundamental of one single price which implies that market

remains in equilibrium and two identical securities, having same

degree of risk will command same price, i.e. will have same return in

the market in the long run. However, due to the short term

disequilibrium, there may be difference in the return of two securities

with the same risk level, which will attract the process of arbitrage

and investors will be able to generate safe returns.

CONCEPT OF ARBITRAGE PRICING

THEORY (APT)

This model has been developed by S Ross, using a notion that

security returns are not based on one single factor (index) of the

market; instead each security is linked with multiple factors and

returns get influenced by these factors. APT believes that the return

generating process of a particular security/portfolio does not get

influenced by its association with the market portfolio; rather it is

influenced by several logical factors gross domestic product

(GDP), national income, personal disposable income, inflation,

interest rate, consumer price index, wholesale price index, bank

rate, foreign exchange rate, etc. APT also emphasizes the

fundamental of one single price which implies that market

remains in equilibrium and two identical securities, having same

degree of risk will command same price, i.e. will have same return in

the market in the long run. However, due to the short term

disequilibrium, there may be difference in the return of two securities

with the same risk level, which will attract the process of arbitrage

and investors will be able to generate safe returns.

CONCEPT OF ARBITRAGE PRICING

THEORY (APT)

APT is one of the modern portfolio theories, which is based

on the rational behavior of investors. Theory is of one price

opinion , which implies that two identical securities with

same level of risk must have same return; if due to certain

imperfections in the market these offer different returns, then

investors would sell the security with low return and buy the

ith hi h tone with high return.

Arbitrage pricing theory has two basic outcomes it helps in

assigning price to securities by identifying the

securities/portfolios as

a) Underpriced

b) Overpriced

c) Efficiently priced

CONCEPT OF ARBITRAGE PRICING

THEORY (APT)

APT is one of the modern portfolio theories, which is based

on the rational behavior of investors. Theory is of one price

opinion , which implies that two identical securities with

same level of risk must have same return; if due to certain

imperfections in the market these offer different returns, then

investors would sell the security with low return and buy the

ith hi h tone with high return.

Arbitrage pricing theory has two basic outcomes it helps in

assigning price to securities by identifying the

securities/portfolios as

a) Underpriced

b) Overpriced

c) Efficiently priced

CONCEPT OF ARBITRAGE PRICING

THEORY (APT)

It also focuses on the fact that returns for a particular share is

derived from its association will multiple factors, i.e. more than

one factor affecting the performance of the company. This

association of an individual share/portfolios with different

factors is established with the help of a sensitivity factor called

beta. In single index model and CAPM, each share has only

b t h i th l ti hi f t f th h ith one beta showing the relationship of returns o

f the share with

the index of the market or market portfolio. But in APT, there

are more than one beta value for a particular share; return of

a share with each of the factors are shown with the help of a

separate beta value. For example, a share is affected by

seven factors then it will have seven beta values, each

showing relationship of the returns of the share with the factor

separately. Due to the relationship with many factors, it is

called MULTIPLE FACTOR MODEL.

CONCEPT OF ARBITRAGE PRICING

THEORY (APT)

It also focuses on the fact that returns for a particular share is

derived from its association will multiple factors, i.e. more than

one factor affecting the performance of the company. This

association of an individual share/portfolios with different

factors is established with the help of a sensitivity factor called

beta. In single index model and CAPM, each share has only

b t h i th l ti hi f t f th h ith one beta showing the relationship of returns o

f the share with

the index of the market or market portfolio. But in APT, there

are more than one beta value for a particular share; return of

a share with each of the factors are shown with the help of a

separate beta value. For example, a share is affected by

seven factors then it will have seven beta values, each

showing relationship of the returns of the share with the factor

separately. Due to the relationship with many factors, it is

called MULTIPLE FACTOR MODEL.

ASSUMPTIONS OF APT

Arbitrage pricing theory is based upon certain assumptions if

these assumptions are found valid then the findings and logic

of the model are applicable. These assumptions are as

follows:

1. Investors are risk averse and utility maximisers

2. Investors have homogenous beliefs

3. Market are perfect

4. Multi factor affect

5. Dominance principle

6. Equilibrium of the market

7. Efficient frontier

ASSUMPTIONS OF APT

Arbitrage pricing theory is based upon certain assumptions if

these assumptions are found valid then the findings and logic

of the model are applicable. These assumptions are as

follows:

1. Investors are risk averse and utility maximisers

2. Investors have homogenous beliefs

3. Market are perfect

4. Multi factor affect

5. Dominance principle

6. Equilibrium of the market

7. Efficient frontier

INVESTORS ARE RISK AVERSE AND

UTILITY MAXIMISERS

1. APT is based on the assumptions that each investors is risk

averse i.e. has the tendency to either avoid the risk or

minimize it. It is believed that every investor prefers high

return as compared to low return for a given level of risk.

Investors need to be compensated suitably for the risk

assumed by them. Utility maximization implies that investors

f t i i t t i l lth f th i t t bprefer to maximize to terminal wealth of the inv

estment by

selecting such avenues, which offer maximum return for the

risk preference of the investors. The combined effect of risk

aversion and utility maximization is that, investors select the

securities/ portfolio using the dominance principle.

INVESTORS ARE RISK AVERSE AND

UTILITY MAXIMISERS

1. APT is based on the assumptions that each investors is risk

averse i.e. has the tendency to either avoid the risk or

minimize it. It is believed that every investor prefers high

return as compared to low return for a given level of risk.

Investors need to be compensated suitably for the risk

assumed by them. Utility maximization implies that investors

f t i i t t i l lth f th i t t bprefer to maximize to terminal wealth of the inv

estment by

selecting such avenues, which offer maximum return for the

risk preference of the investors. The combined effect of risk

aversion and utility maximization is that, investors select the

securities/ portfolio using the dominance principle.

INVESTORS HAVE HOMOGENOUS

BELIEFS

2. Homogenous belief implies that each investors has similar

kind of risk return estimate about different investment

avenues. This assumption has direct impact on the

identification of securities into different categories. Arbitrage

pricing theory has an objective to assign value to different

securities in the sense that it helps in identifying these into

th diff t d ti t i Thi t i ti three different and executive categories. This cat

egorization

is done by comparing expected returns with the realized

returns from a security. It is done as follows.

I. Undervalued securities having expected return < realized return

II. Efficiently priced securities having expected return = realized

return

III. Overvalued securities having expected return > realized return

All this identification is similar in manner by almost all investors

as each one has homogenous estimate about the expected

return and risk about securities.

INVESTORS HAVE HOMOGENOUS

BELIEFS

2. Homogenous belief implies that each investors has similar

kind of risk return estimate about different investment

avenues. This assumption has direct impact on the

identification of securities into different categories. Arbitrage

pricing theory has an objective to assign value to different

securities in the sense that it helps in identifying these into

th diff t d ti t i Thi t i ti three different and executive categories. This cat

egorization

is done by comparing expected returns with the realized

returns from a security. It is done as follows.

I. Undervalued securities having expected return < realized return

II. Efficiently priced securities having expected return = realized

return

III. Overvalued securities having expected return > realized return

All this identification is similar in manner by almost all investors

as each one has homogenous estimate about the expected

return and risk about securities.

MARKETS ARE PERFECT

3. Perfect market condition is the supporting base

for arbitrage pricing theory. It implies that there

are large number of investors as soon as such

information gets generated. This happens only

when different segments of the market work on

the principle of full disclosure and

transparency. The result of this is that none of

the investors is in a position to create any kind

of extra impact in the market by unduly

influencing the share prices. The ultimate result

of perfect market condition is that,

securities/portfolios are priced efficiently in the

long run.

MARKETS ARE PERFECT

3. Perfect market condition is the supporting base

for arbitrage pricing theory. It implies that there

are large number of investors as soon as such

information gets generated. This happens only

when different segments of the market work on

the principle of full disclosure and

transparency. The result of this is that none of

the investors is in a position to create any kind

of extra impact in the market by unduly

influencing the share prices. The ultimate result

of perfect market condition is that,

securities/portfolios are priced efficiently in the

long run.

MULTI FACTOR EFFECT

4. Single index model of sharpe and CAPM are based on the

assumption that each security/portfolio has an association with only

one factor of the market and this factor is either the market portfolio

or index of the market. Contrary to this, APT believes that each

security has an association with more than one factor. The theory

does not talk about the type and number of factors. Accordingly,

return and risk of an individual security or portfolio will always be

influenced by more than one factor, these may be such factors

having direct effect on the performance of the company, like market

share of the company, foreign exchange rate if the company has

import export business, inflation rate, interest rate, monetary policy

parameters in case of a bank or financial institution, gross domestic

product and national income affecting the demand for the product

of the company, etc. This association of each individual factor

affecting with the returns of the share is represented through beta

of the security s return with the individual factor.

MULTI FACTOR EFFECT

4. Single index model of sharpe and CAPM are based on the

assumption that each security/portfolio has an association with only

one factor of the market and this factor is either the market portfolio

or index of the market. Contrary to this, APT believes that each

security has an association with more than one factor. The theory

does not talk about the type and number of factors. Accordingly,

return and risk of an individual security or portfolio will always be

influenced by more than one factor, these may be such factors

having direct effect on the performance of the company, like market

share of the company, foreign exchange rate if the company has

import export business, inflation rate, interest rate, monetary policy

parameters in case of a bank or financial institution, gross domestic

product and national income affecting the demand for the product

of the company, etc. This association of each individual factor

affecting with the returns of the share is represented through beta

of the security s return with the individual factor.

MULTI FACTOR EFFECT contd

Beta represents the volatility of the returns from

the share for every one percent change in the

returns of the associated factor. For example

share X has beta 0.50 with factor A and with

factor B its beta is 0.35; now when factor A

shows an upward movement by 1 percent then shows an upward movement by 1 percent

, then

the return of this share X on account of this will

increase by 0.50 percent and similarly, when

factor B shows and upward movement by 1

percent then also the return of this share will

increase by 0.35 percent. Similarly, when these

factors show a decline, the returns from this

share will decrease correspondingly.

MULTI FACTOR EFFECT contd

Beta represents the volatility of the returns from

the share for every one percent change in the

returns of the associated factor. For example

share X has beta 0.50 with factor A and with

factor B its beta is 0.35; now when factor A

shows an upward movement by 1 percent then shows an upward movement by 1 percent

, then

the return of this share X on account of this will

increase by 0.50 percent and similarly, when

factor B shows and upward movement by 1

percent then also the return of this share will

increase by 0.35 percent. Similarly, when these

factors show a decline, the returns from this

share will decrease correspondingly.

DOMINANCE PRINCIPLE

5. Dominance principle implies that one security outperforms the

other for the same price. Similarly, it may be that one portfolio

outperforms the other for the same given price. By price here,

we mean the level of risk. It is dominance principle which

helps in identifying efficient portfolios and generation of

efficient frontier. The fundamental of dominance principle can

be understood with the help of the following graph.be understood with the help o

f the following graph.

Here for the risk level 1 percent standard deviation we have

two corresponding securities one is having 20 percent return

and the other is having 15 percent, one with 20 percent return

dominates the other as it is giving more return for the same

level of risk. Similarly, if we look from the return, side for 15

percent return, there are two securities one having risk 1

percent and another having risk 1.5 percent. Certainly, the

security with 1 percent risk measurement dominates the

another.

DOMINANCE PRINCIPLE

5. Dominance principle implies that one security outperforms the

other for the same price. Similarly, it may be that one portfolio

outperforms the other for the same given price. By price here,

we mean the level of risk. It is dominance principle which

helps in identifying efficient portfolios and generation of

efficient frontier. The fundamental of dominance principle can

be understood with the help of the following graph.be understood with the help o

f the following graph.

Here for the risk level 1 percent standard deviation we have

two corresponding securities one is having 20 percent return

and the other is having 15 percent, one with 20 percent return

dominates the other as it is giving more return for the same

level of risk. Similarly, if we look from the return, side for 15

percent return, there are two securities one having risk 1

percent and another having risk 1.5 percent. Certainly, the

security with 1 percent risk measurement dominates the

another.

Equilibrium of the market :

6. Equilibrium of the market : APT relies on the

fact that securities markets function in

equilibrium, which implies that the price of two

identical securities having the same degree of

risk must be the same. It clearly helps inrisk must be the same. It clearly help

s in

making an interpretation that two securities

having same level of risk must generate same

return in the long run. Thus, equilibrium

theorem creates homogenous beliefs of the

investors and helps in identifying mispricing of

the securities. This is the basis of bringing in

the concept of efficient portfolio.

Equilibrium of the market :

6. Equilibrium of the market : APT relies on the

fact that securities markets function in

equilibrium, which implies that the price of two

identical securities having the same degree of

risk must be the same. It clearly helps inrisk must be the same. It clearly help

s in

making an interpretation that two securities

having same level of risk must generate same

return in the long run. Thus, equilibrium

theorem creates homogenous beliefs of the

investors and helps in identifying mispricing of

the securities. This is the basis of bringing in

the concept of efficient portfolio.

Equilibrium of the market

contd

However, due to short-term disequilibrium,

two securities with identical risk level

might have different returns which will

attract the process of arbitrage. As a result

of the arbitrage process, securities will be

priced efficiently in the long run and find a

place on the efficient frontier. The

implication of equilibrium of market results

in the law of one price, i.e. securities with

identical risk must generate same return.

Equilibrium of the market

contd

However, due to short-term disequilibrium,

two securities with identical risk level

might have different returns which will

attract the process of arbitrage. As a result

of the arbitrage process, securities will be

priced efficiently in the long run and find a

place on the efficient frontier. The

implication of equilibrium of market results

in the law of one price, i.e. securities with

identical risk must generate same return.

Efficient frontier

7. Efficient frontier: An efficient frontier is the

line on risk-return graph, joining all corner

portfolios. A corner portfolio is the one, which is

either efficient in itself or is created by

combining certain efficient portfolios, these combining certain efficient portfo

lios, these

efficient portfolios offer optimum returns for the

given level of risk. It is believed that all the

portfolios, which are priced according to the

fundamentals of market equilibrium, will

generate optimum return for the given level of

risk and will be priced efficiently; consequently

get plotted on the efficient frontier.

Efficient frontier

7. Efficient frontier: An efficient frontier is the

line on risk-return graph, joining all corner

portfolios. A corner portfolio is the one, which is

either efficient in itself or is created by

combining certain efficient portfolios, these combining certain efficient portfo

lios, these

efficient portfolios offer optimum returns for the

given level of risk. It is believed that all the

portfolios, which are priced according to the

fundamentals of market equilibrium, will

generate optimum return for the given level of

risk and will be priced efficiently; consequently

get plotted on the efficient frontier.

Efficient frontier contd

As market is considered to be efficient,

each security and portfolio should fall on

the efficient frontier in the long-run. This

presence and knowledge of efficient

frontier helps in the identification of

different securities and portfolios as

(a) underpriced,

(b) priced efficiently, and

(c) overpriced.

Efficient frontier contd

As market is considered to be efficient,

each security and portfolio should fall on

the efficient frontier in the long-run. This

presence and knowledge of efficient

frontier helps in the identification of

different securities and portfolios as

(a) underpriced,

(b) priced efficiently, and

(c) overpriced.

Efficient frontier contd

Securities or portfolios, which get plotted

above the efficient frontier are underpriced

and securities or portfolios below the

efficient frontier are overpriced. This

identification will lead to' arbitrage process

and ultimately, each security and portfolio

will be on the efficient frontier in the long-

run.

Efficient frontier contd

Securities or portfolios, which get plotted

above the efficient frontier are underpriced

and securities or portfolios below the

efficient frontier are overpriced. This

identification will lead to' arbitrage process

and ultimately, each security and portfolio

will be on the efficient frontier in the long-

run.

Expected Return & Risk Under

APT

Expected returns : By expected return, we mean

the most likely level of the return, which should be

maintained as per the performance of the company

and association of individual share with different

factors. An estimate about the most likely return factors. An estimate about the

most likely return

can be made once forecast about the different

factors and beta value is available. Total expected

return can be bifurcated into two -return on

account of company's performance called Alpha

and return on account of security's association with

the multiple factors called Systematic Component

of Return.

Expected Return & Risk Under

APT

Expected returns : By expected return, we mean

the most likely level of the return, which should be

maintained as per the performance of the company

and association of individual share with different

factors. An estimate about the most likely return factors. An estimate about the

most likely return

can be made once forecast about the different

factors and beta value is available. Total expected

return can be bifurcated into two -return on

account of company's performance called Alpha

and return on account of security's association with

the multiple factors called Systematic Component

of Return.

Expected Return & Risk Under

APT contd .

Alpha : Alpha component of the return is on

account of performance of the company. It can be

termed as the return, which can be expected if all

other factors have zero-value or the security has

zero-beta with all the factors. Alpha component of zero beta with all the factor

s. Alpha component of

return is also termed as zero beta return.

Systematic component return :This is such part

of the total expected return, which is on account of

the association of the security with different

systematic factors, which affect returns from the

share. This is represented with the help of beta.

Expected Return & Risk Under

APT contd .

Alpha : Alpha component of the return is on

account of performance of the company. It can be

termed as the return, which can be expected if all

other factors have zero-value or the security has

zero-beta with all the factors. Alpha component of zero beta with all the factor

s. Alpha component of

return is also termed as zero beta return.

Systematic component return :This is such part

of the total expected return, which is on account of

the association of the security with different

systematic factors, which affect returns from the

share. This is represented with the help of beta.

Expected Return & Risk Under

APT contd .

Random error term This represents extraordinary

return from a security only when some extraordinary

event like merger, acquisition, takeover, bonus

declaration, etc., takes place. Generally, it is

considered as zero.considered as zero.

The expectation of return from a particular security

is based on the association of the security with the

factors affecting the return. As per APT theorem, the

following equation represents the expected return of

a security:

Expected Return & Risk Under

APT contd .

Random error term This represents extraordinary

return from a security only when some extraordinary

event like merger, acquisition, takeover, bonus

declaration, etc., takes place. Generally, it is

considered as zero.considered as zero.

The expectation of return from a particular security

is based on the association of the security with the

factors affecting the return. As per APT theorem, the

following equation represents the expected return of

a security:

Expected Return & Risk Under

APT contd .

Expected Return =

iijnijijijiejnjjj+×++×++××+bbbba...... 321 321

Expected Return & Risk Under

APT contd .

Expected Return =

iijnijijijiejnjjj+×++×++××+bbbba...... 321 321

Expected Return & Risk Under

APT contd .

return beta zero or companythe

of eperformanc the of accounton return i.e.return,systematic-Non =ia

p y

j1' 'as named factor first

ith the security w of beta 1 =ijb

Expected Return & Risk Under

APT contd .

return beta zero or companythe

of eperformanc the of accounton return i.e.return,systematic-Non =ia

p y

j1' 'as named factor first

ith the security w of beta 1 =ijb

Expected Return & Risk Under

APT contd .

j2' 'as named factor second the

ith security wthe of beta 2 =ijb

j1= value of the first factor named as j1 j1 value of the first factor named as j1

j2 = value of the second factor named as j2

error term random =ieExpected Return & Risk Under

APT contd .

j2' 'as named factor second the

ith security wthe of beta 2 =ijb

j1= value of the first factor named as j1 j1 value of the first factor named as j1

j2 = value of the second factor named as j2

error term random =ie

RISK

Expected return from a security is subject to some

kind of fluctuation. This fluctuation may be positive

or negative. Fluctuation in the expected return is

represented with the help of variance in the return.

As expected return is divided into two -alpha

component and systematic component; similarly,

risk of a share can also be divided into two -

systematic risk on account of system-wide factors

and non-systematic risk on account of company-

wide factors. Risk of a share is represented with

the help of the following equation. Risk is represent

as variance of the expected return which is as

follows

RISK

Expected return from a security is subject to some

kind of fluctuation. This fluctuation may be positive

or negative. Fluctuation in the expected return is

represented with the help of variance in the return.

As expected return is divided into two -alpha

component and systematic component; similarly,

risk of a share can also be divided into two -

systematic risk on account of system-wide factors

and non-systematic risk on account of company-

wide factors. Risk of a share is represented with

the help of the following equation. Risk is represent

as variance of the expected return which is as

follows

RISK CONTD .

)var( )var( .... )2var( )1var( )var( 2

2

2

1

2 ejnjjiijnijij+×+×+×=bbb

Var (i) = Variance of expected return of i' security

Var (j1) = Variance of factor 'j1'

2'as namedfactor secondith thesecurity wthe of beta

'1'as namedfactor first ith thesecurity wthe of beta

2

1

jjijij

=

=

b

b

Var (j2) = Variance of factor 'j2'

Var (e) = Company-specific risk/non-systematic risk on account of

company-wide factors

RISK CONTD .

)var( )var( .... )2var( )1var( )var( 2

2

2

1

2 ejnjjiijnijij+×+×+×=bbb

Var (i) = Variance of expected return of i' security

Var (j1) = Variance of factor 'j1'

2'as namedfactor secondith thesecurity wthe of beta

'1'as namedfactor first ith thesecurity wthe of beta

2

1

jjijij

=

=

b

b

Var (j2) = Variance of factor 'j2'

Var (e) = Company-specific risk/non-systematic risk on account of

company-wide factors

Beta: Beta of a security is the sensitivity

measurement, representing volatility of the

return for a given change in the factor to which

this beta value associates. Beta is calculated by

considering considering covariance of the security s return

covariance of the security's return

and value of the related factor. For example, a

share has beta of 1.20 with factor' Y', then it

means for every one per cent change in the

factor' Y', the returns from this share will change

by 1.20% only due to this factor. It is calculated

as follows:

BETA

1

2

1,

1

covariance

jjiij

s

b=

'1'factor with the ''security the of beta 1 jiij=b

'1'factor of variance

return affecting factors the of one '1'

security individual ''

1

2 jjij=

=

=

s

Using this formula, beta of the security with each factor can be calculated sepa

rately

BETA

1

2

1,

1

covariance

jjiij

s

b=

'1'factor with the ''security the of beta 1 jiij=b

'1'factor of variance

return affecting factors the of one '1'

security individual ''

1

2 jjij=

=

=

s

Using this formula, beta of the security with each factor can be calculated sepa

rately

Calculation of expected return using APT

equation

Illustration 1, pg no. 454Illustration 1, pg no. 454

Calculation of expected return using APT

equation

Illustration 1, pg no. 454Illustration 1, pg no. 454

The Arbitrage Process

A combined effect of investor's utility

maximization theorem, homogenous beliefs of

investors and perfect markets is that,

securities are priced efficiently in the long-run.

Two identical securities with the same level of

risk (OJ) must have the same price, i.e. mean

return for each of the security. However, due

to market imperfections and short-term,

disequilibrium in the market, two identical

securities might be priced differently; but this

will last only in the short run.

The Arbitrage Process

A combined effect of investor's utility

maximization theorem, homogenous beliefs of

investors and perfect markets is that,

securities are priced efficiently in the long-run.

Two identical securities with the same level of

risk (OJ) must have the same price, i.e. mean

return for each of the security. However, due

to market imperfections and short-term,

disequilibrium in the market, two identical

securities might be priced differently; but this

will last only in the short run.

The Arbitrage Process

For example, two securities have the same

level of risk, i.e. a standard deviation of 3%

but these are having a return of 15 %(low

yielding share) and 17% (high yielding

h ) thi diff i th t ill share), this difference in the returns will

attract the process of arbitrage. This will

imply that investors. who have security,

giving 15% return will sell and buy the

security with 17% return so that they can

have more return by having the same level

of risk.

The Arbitrage Process

For example, two securities have the same

level of risk, i.e. a standard deviation of 3%

but these are having a return of 15 %(low

yielding share) and 17% (high yielding

h ) thi diff i th t ill share), this difference in the returns will

attract the process of arbitrage. This will

imply that investors. who have security,

giving 15% return will sell and buy the

security with 17% return so that they can

have more return by having the same level

of risk.

The Arbitrage Process

This process will create a supply for low

yielding share and demand for high yielding;

consequently prices of the earlier will

decline, leading to an increase in the yield

and prices of the later will rise, leading to

decline in the yield. The change in the yield

will ultimately bring both the securities at

equilibrium and both will lie on the efficient

frontier.

The Arbitrage Process

This process will create a supply for low

yielding share and demand for high yielding;

consequently prices of the earlier will

decline, leading to an increase in the yield

and prices of the later will rise, leading to

decline in the yield. The change in the yield

will ultimately bring both the securities at

equilibrium and both will lie on the efficient

frontier.

The Arbitrage Process

By arbitrage in portfolio context, we mean selling the

securities or portfolios, which generate low or less return for

a particular level of risk and buying the other security or

portfolio, having same level of risk but generating high or

more return. This happens because of the risk-aversion

behaviour and utility maximization by the investors The behaviour and utility ma

ximization by the investors. The

effect of this process is that, the price of the security/portfolio

with low return starts declining on account of increased

supply and price of the security with high return increases on

account of increased demand. This arbitrage process will

continue till the time both the securities do not find a place

on the efficient frontier. This process is explained with the

help of following example:

The Arbitrage Process

By arbitrage in portfolio context, we mean selling the

securities or portfolios, which generate low or less return for

a particular level of risk and buying the other security or

portfolio, having same level of risk but generating high or

more return. This happens because of the risk-aversion

behaviour and utility maximization by the investors The behaviour and utility ma

ximization by the investors. The

effect of this process is that, the price of the security/portfolio

with low return starts declining on account of increased

supply and price of the security with high return increases on

account of increased demand. This arbitrage process will

continue till the time both the securities do not find a place

on the efficient frontier. This process is explained with the

help of following example:

The Arbitrage Process

Portfolio Mean return in % Risk

A 10 1

B 15 1.5

%s

C 20 2

U 17 1.25

O 9 1.25

O2 13 1.50

The Arbitrage Process

Portfolio Mean return in % Risk

A 10 1

B 15 1.5

%s

C 20 2

U 17 1.25

O 9 1.25

O2 13 1.50

The Arbitrage Process

By reading the data given in the table and

also plotted on the graph above, a portfolio

manager can identify that the portfolios A, U

& C are on efficient frontier, whereas

portfolios B, 0 and 02 do not find a place on portfolios B, 0 and 02 do not find

a place on

the efficient frontier. Here, portfolio U

having return 17 per cent with a risk of 1.25

per cent is under priced and another

portfolio with the same level of risk (1.25

per cent) has the return of only 9 per cent is

over-priced. This identification will lead to

arbitrage process.

The Arbitrage Process

By reading the data given in the table and

also plotted on the graph above, a portfolio

manager can identify that the portfolios A, U

& C are on efficient frontier, whereas

portfolios B, 0 and 02 do not find a place on portfolios B, 0 and 02 do not find

a place on

the efficient frontier. Here, portfolio U

having return 17 per cent with a risk of 1.25

per cent is under priced and another

portfolio with the same level of risk (1.25

per cent) has the return of only 9 per cent is

over-priced. This identification will lead to

arbitrage process.

Generating profit with zero initial

outflow

Now, an investor can generate extra return with zero

initial outflow. Let us assume that an investor short sells

(selling the share or portfolio without having it with the

understanding of buying it back in the future or having

arbitrage profit) portfolio '0' of the value Rs 10,000 and

buys the portfolio U' by using these Rs 10 000 After buys the portfolio U by usin

g these Rs 10,000. After

doing this and waiting for a period of one year, he has to

pay 9 per cent for the short sale of the portfolio '0' but he

will receive 17 per cent from the portfolio U'. Thus with

the help of arbitrage, he can earn 8 per cent return with

zero initial outflow, now he might reverse the deal, i.e.

selling portfolio U' and cover the short sale of '0' by

buying it.

Generating profit with zero initial

outflow

Now, an investor can generate extra return with zero

initial outflow. Let us assume that an investor short sells

(selling the share or portfolio without having it with the

understanding of buying it back in the future or having

arbitrage profit) portfolio '0' of the value Rs 10,000 and

buys the portfolio U' by using these Rs 10 000 After buys the portfolio U by usin

g these Rs 10,000. After

doing this and waiting for a period of one year, he has to

pay 9 per cent for the short sale of the portfolio '0' but he

will receive 17 per cent from the portfolio U'. Thus with

the help of arbitrage, he can earn 8 per cent return with

zero initial outflow, now he might reverse the deal, i.e.

selling portfolio U' and cover the short sale of '0' by

buying it.

Table showing arbitrage profit

through zero initial investment

Present cash

flow

Return after one

year

Cash flow after

one year

Short sell O +10000 -900 -10000

Buy U -10000 + 1700 + 10000

Net cash flow 0 +800 0

Thus, by making such arbitrage, one can have Rs 800 with

zero initial investment.

Likewise, portfolio B has risk 1.5 per cent and return 15 per

cent; at the same time, we can observe that the portfolio '02'

also has a risk of 1.5 per cent but its' return is only 13 per

cent. Here portfolio '02' is identified as overvalued and 'B' as

efficient as it is on the efficient frontier.

Table showing arbitrage profit

through zero initial investment

Present cash

flow

Return after one

year

Cash flow after

one year

Short sell O +10000 -900 -10000

Buy U -10000 + 1700 + 10000

Net cash flow 0 +800 0

Thus, by making such arbitrage, one can have Rs 800 with

zero initial investment.

Likewise, portfolio B has risk 1.5 per cent and return 15 per

cent; at the same time, we can observe that the portfolio '02'

also has a risk of 1.5 per cent but its' return is only 13 per

cent. Here portfolio '02' is identified as overvalued and 'B' as

efficient as it is on the efficient frontier.

Limitation of APT

Arbitrage Pricing Theory has practical

implication, as it considers association of the

security and portfolio with more than one factor

affecting return and risk. It is an improvement

over Sharpe's Single Index model and CAPM,

t it h li it ti :yet it has limitations:

It does not specify the type and number of factors

affecting return and risk

It is difficult to identify the factors affecting return and

risk

Different investors might identify different factors for

the same security/portfolio; this will violate the

assumption of homogenous beliefs

Limitation of APT

Arbitrage Pricing Theory has practical

implication, as it considers association of the

security and portfolio with more than one factor

affecting return and risk. It is an improvement

over Sharpe's Single Index model and CAPM,

t it h li it ti :yet it has limitations:

It does not specify the type and number of factors

affecting return and risk

It is difficult to identify the factors affecting return and

risk

Different investors might identify different factors for

the same security/portfolio; this will violate the

assumption of homogenous beliefs

Limitation of APT contd

Difficulty in calculating different beta values

Effect of one factor on the return and risk can

not be assessed precisely

If the list of factors affecting the return and

risk is infinite, then this theory does not find

the practical implication

With passage of time, type and number of

factors for one security/portfolio might

change, leading to inconsistency in

comparison.

Limitation of APT contd

Difficulty in calculating different beta values

Effect of one factor on the return and risk can

not be assessed precisely

If the list of factors affecting the return and

risk is infinite, then this theory does not find

the practical implication

With passage of time, type and number of

factors for one security/portfolio might

change, leading to inconsistency in

comparison.

CONCLUSION

Arbitrage Pricing Theory is an improvement over the

single index model like that of Sharpe or CAPM.

This theory believes that each security and portfolio

has relationship with more than one factor and this

relationship affects the return of it. APT does not

specify the type and number of factors affecting

returns from a security/portfolio, but it discusses that

one single factor cannot influence returns and risk of

a security/portfolio. Instead, return and risk are

influenced by a set of multiple factors. Due to this, it

is also called as multi-factor model. Theory rests

upon the basic assumption of risk-averse and utility

maximization behaviour of the investors.

CONCLUSION

Arbitrage Pricing Theory is an improvement over the

single index model like that of Sharpe or CAPM.

This theory believes that each security and portfolio

has relationship with more than one factor and this

relationship affects the return of it. APT does not

specify the type and number of factors affecting

returns from a security/portfolio, but it discusses that

one single factor cannot influence returns and risk of

a security/portfolio. Instead, return and risk are

influenced by a set of multiple factors. Due to this, it

is also called as multi-factor model. Theory rests

upon the basic assumption of risk-averse and utility

maximization behaviour of the investors.

CONCLUSION CONTD .

It also assumes that markets are perfect and each

security and portfolio is in equilibrium in the long run.

Due to this equilibrium, two identical securities must

have the same return. However, certain short-term

disequilibrium in the market can create distortion in the

return of these securities, which will attract the process return of these secur

ities, which will attract the process

of arbitrage. Accordingly, if two securities have same

level of risk, but are giving different return, then people

will sell low yielding security and buy high yielding

security, this process is called arbitrage. This arbitrage

will finally put all the securities/portfolio on the efficient

frontier. An efficient frontier is the one, which is created

by joining the entire comer portfolio on the risk-return

graph.

CONCLUSION CONTD .

It also assumes that markets are perfect and each

security and portfolio is in equilibrium in the long run.

Due to this equilibrium, two identical securities must

have the same return. However, certain short-term

disequilibrium in the market can create distortion in the

return of these securities, which will attract the process return of these secur

ities, which will attract the process

of arbitrage. Accordingly, if two securities have same

level of risk, but are giving different return, then people

will sell low yielding security and buy high yielding

security, this process is called arbitrage. This arbitrage

will finally put all the securities/portfolio on the efficient

frontier. An efficient frontier is the one, which is created

by joining the entire comer portfolio on the risk-return

graph.

THANK YOU THANK YOU

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