Arbitrage pricing theory - Wikipedia. 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 discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. The theory was proposed by the economist. Stephen Ross in 1. Risky asset returns are said to follow a factor intensity structure if they can be expressed as: rj=aj+bj. F1+bj. 2F2+. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap. 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 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. 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. When the investor is long the asset and 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: Where today's price is too low: 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. At the end of the period. Where today's price is too high: 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. At the end of the period. Relationship with the capital asset pricing model. 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. Arbitrage Pricing Theory Pdf FreeIt assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical . In some ways, the CAPM can be considered a . Thus, factor shocks would cause structural changes in assets' expected returns, or in the case of stocks, in firms' profitabilities. On the other side, the capital asset pricing model is considered a . 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 . 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 in nature. Several a priori guidelines as to the characteristics required of potential factors are, however, suggested: their impact on asset prices manifests in their unexpected movementsthey should represent undiversifiable influences (these are, clearly, more likely to be macroeconomic rather than firm- specific in nature)timely and accurate information on these variables is requiredthe relationship should be theoretically justifiable on economic grounds. Chen, Roll and Ross (1. GNP as indicated by an industrial production index; surprises in investor confidence due to changes in default premium in corporate bonds; surprise shifts in the yield curve. 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. IEOR E4706: Financial Engineering: Discrete-Time Asset Pricing Fall 2005 Preliminary versions of economic research. In advanced economies, a century-long near-stable ratio of credit to GDP gave way to rapid financialization and surging leverage in the last forty years. Market indices are sometimes derived by means of factor analysis. Roll, Richard; Ross, Stephen (1. Journal of Economic Theory. Chen, Nai- Fu; Roll, Richard; Ross, Stephen (1. 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. Foundations of Finance: Options: Valuation and (No) Arbitrage 4 III. No Arbitrage Pricing Bound The general approach to option pricing is first to assume that prices do not provide arbitrage opportunities. Journal of Comprehensive Research An empirical investigation, page 2 INTRODUCTION The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically. Marginal Cost Pricing Method The practice of setting the price of a product to equal the extra cost of producing an extra unit of output is called marginal pricing in economics. By this policy, a producer charges for each. International Journal of Business and Social Science Vol. 20; November 2011 85 The Economic Determinants of Systematic Risk in the Jordanian Capital Market Khaldoun M. Al-Qaisi Assistant Prof. Stochastic Portfolio Theory: an Overview ROBERT FERNHOLZ INTECH One Palmer Square Princeton, NJ 08542, USA [email protected] IOANNIS KARATZAS Department of Mathematics Columbia University New York, NY 10027, USA ik@math. Arbitrage trades are necessarily synthetic, leveraged trades, as they involve a short position. If the assets used are not identical (so a price divergence makes the trade temporarily lose money), or the margin treatment is.
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