The Arbitrage Pricing Theory(Chapter 10).ppt

The Arbitrage Pricing Theory(Chapter 10) Single-Factor APT Model Multi-Factor APT Models Arbitrage Opportunities Disequilibrium in APT Is APT Testable? Consistency of APT and CAPM Essence of the Arbitrage Pricing Theory Given the impossibility of empirically verifying the CAPM, an alternative model of asset pricing called the Arbitrage Pricing Theory (APT) has been introduced. Essence of APT A security’s expected return and risk are directly related to its sensitivities to changes in one or more factors (e.g., inflation, interest rates, productivity, etc.) Essence of the Arbitrage Pricing Theory(Continued) In other words, security returns are generated by a single-index (one factor) model: where: or, by a multi-index (multi-factor) model: Single-Factor APT Model(A Comparison With the CAPM) CAPM (Zero Beta Version) Factor = Market Portfolio Actual Returns: Expected Returns: APT (One Factor Version) Factor = “Your Choice” Actual Returns: Expected Returns: Single-Factor APT Model(A Comparison With the CAPM)Continued CAPM (Zero Beta Version) Continued Portfolio Variance: APT (One Factor Version) Continued Portfolio Variance: Multi-Factor APT Models One Factor Two Factors Multi-Factor APT Models(Continued) N Factors The Ideal APT Model Ideally, you wish to have a model where all of the covariances between the rates of return to the securities are attributable to the effects of the factors. The covariances between the residuals of the individual securities, Cov(?j, ?k), are assumed to be equal to zero. APT With an Unlimited Number of Securities Given an infinite number of securities, if security returns are generated by a process equivalent to that of a linear single-factor or multi-factor model, it is impossible to construct two different portfolios, both having zero variance (i.e., zero betas and zero residual variance) with two different expected rates of return. In other words, pure riskless arbitrage opportuni