A “few surprises” could be the trivial answer of the Arbitrage Pricing Theory if asked for the major determinants of stock returns. The APT was developed as a traceable framework of the main principles of capital asset pricing in financial markets. It investigates the causes underlying one of the most important fields in financial economics, namely the relationship between risk and return. The APT provides a thorough understanding of the nature and origins of risk inherent in financial assets and how capital markets reward an investor for bearing risk. Its fundamental intuition is the absence of arbitrage which is, indeed, central to finance and which has been used in virtually all areas of financial study. Since its introduction two decades ago, the APT has been subject to extensive theoretical as well as empirical research. By now, the arbitrage theory is well established in both respects and has enlightened our perception of capital markets. This paper aims to present the APT as an appropriate instrument of capital asset pricing and to link its principles to the valuation of risky income streams. The objective is also to provide an overview of the state of art of APT in the context of alternative capital market theories. For this purpose, Section 2 describes the basic concepts of the traditional asset pricing model, the CAPM, and indicates differences to arbitrage theory. Section 3 constitutes the main part of this paper introducing a derivation of the APT. Emphasis is laid on principles rather than on rigorous proof. The intuition of the pricing formula and its consistency with the state space preference theory are discussed. Important contributions to the APT are classified and briefly reviewed, the question of APT’s empirical evidence and of its risk factors is attempted to be answered. In Section 4, arbitrage theory is linked to traditional as well as to innovative valuation methods. It includes a discussion of the DCF method, arbitrage valuation and previews an option pricing approach to security valuation. Finally, Section 5 concludes the paper with some practical considerations from the investment community.
Table of Contents
- 1. Introduction
- 2. Overview of asset pricing in modern capital market theory
- 2.1 Classification
- 2.2 The Capital Asset Pricing Model
- 2.2.1 Assumptions
- 2.2.2 Capital Market Line and Security Market Line
- 2.2.3 Major implications
- 2.2.4 Extensions of the Capital Asset Pricing Model
- 2.3 Empirical relevance of mean-variance efficiency models
- 3. The Arbitrage Pricing Theory
- 3.1 The original Arbitrage Pricing Theory of Ross
- 3.1.1 Fundamental principles
- 3.1.1.1 Absence of arbitrage
- 3.1.1.2 Linear k-factor model
- 3.1.2 Formal statement of the theory
- 3.1.2.1 Assumptions
- 3.1.2.2 The basic arbitrage condition
- 3.1.3 Intuition
- 3.1.1 Fundamental principles
- 3.2 Contributions
- 3.2.1 Classification
- 3.2.2 Traditional Arbitrage Pricing Theory
- 3.2.3 Equilibrium Arbitrage Pricing Theory
- 3.3 Empirical evidence and economic factors
- 3.3.1 Testability and testing methods
- 3.3.2 Results from capital markets
- 3.3.3 Identification and interpretation of macroeconomic factors
- 3.1 The original Arbitrage Pricing Theory of Ross
- 4. Arbitrage valuation of risky income streams
- 4.1 Commonly recognized valuation methods
- 4.2 Use of the arbitrage theory in the valuation process
- 4.2.1 Traditional valuation approaches
- 4.2.2 Innovative valuation approaches
- 4.2.2.1 The general arbitrage approach to asset valuation
- 4.2.2.2 The binomial option pricing approach to asset valuation: a prospective
Objectives and Key Themes
This paper aims to explore the Arbitrage Pricing Theory (APT) as an approach to capital asset valuation. It examines the theory's development, its empirical evidence, and its application in practical valuation methods.
- The Capital Asset Pricing Model (CAPM) and its limitations.
- The fundamental principles and mathematical formulation of the APT.
- Empirical evidence supporting and challenging the APT.
- The application of APT in various asset valuation techniques.
- Comparison of traditional and innovative valuation approaches within the context of APT.
Chapter Summaries
1. Introduction: This chapter likely provides a brief overview of the topic, introducing the Arbitrage Pricing Theory (APT) and its significance in capital market theory. It may also outline the structure and objectives of the thesis.
2. Overview of asset pricing in modern capital market theory: This chapter probably lays the groundwork by introducing the fundamental concepts of modern portfolio theory and asset pricing. It likely covers the Capital Asset Pricing Model (CAPM), its assumptions, and its limitations, setting the stage for the introduction of the APT as an alternative approach. The discussion of the CAPM’s empirical relevance helps to contextualize the need for a more robust model, like the APT.
3. The Arbitrage Pricing Theory: This chapter delves into the core of the thesis, presenting the Arbitrage Pricing Theory in detail. It likely starts with Ross's original formulation, explaining its fundamental principles, assumptions, and mathematical representation. Subsequent sections would probably explore different interpretations and extensions of the APT, such as the traditional and equilibrium versions, and critically examine the empirical evidence supporting or contradicting the theory. The discussion on identifying and interpreting macroeconomic factors is likely crucial for understanding the practical application of the APT.
4. Arbitrage valuation of risky income streams: This chapter focuses on the practical application of the APT to the valuation of assets. It likely contrasts traditional valuation methods with those incorporating the APT. This likely includes a detailed explanation of the general arbitrage approach to asset valuation and perhaps explores innovative techniques like binomial option pricing models in the context of arbitrage theory. The comparison allows the reader to see the advantages and disadvantages of each approach.
Keywords
Arbitrage Pricing Theory (APT), Capital Asset Pricing Model (CAPM), Asset Pricing, Valuation, Risk, Return, Portfolio Theory, Factor Models, Arbitrage, Equilibrium, Macroeconomic Factors, Empirical Evidence, Option Pricing.
Frequently Asked Questions: A Comprehensive Language Preview
What is the main topic of this language preview?
This language preview provides a structured overview of a document focusing on the Arbitrage Pricing Theory (APT) within the context of modern capital market theory. It covers the theory's development, empirical evidence, and practical applications in asset valuation.
What are the key themes explored in this document?
The key themes include the Capital Asset Pricing Model (CAPM) and its limitations, the fundamental principles and mathematical formulation of the APT, empirical evidence supporting and challenging the APT, the application of APT in various asset valuation techniques, and a comparison of traditional and innovative valuation approaches within the context of APT.
What is the structure of the document outlined in the preview?
The document is structured into four chapters: An introduction, an overview of asset pricing including the CAPM, a detailed exploration of the Arbitrage Pricing Theory, and finally, a discussion of the arbitrage valuation of risky income streams.
What is covered in the "Overview of asset pricing in modern capital market theory" chapter?
This chapter establishes the foundation by introducing core concepts of modern portfolio theory and asset pricing. It delves into the Capital Asset Pricing Model (CAPM), analyzing its assumptions, limitations, and empirical relevance, setting the stage for the introduction of APT as a potentially superior alternative.
What does the chapter on "The Arbitrage Pricing Theory" encompass?
This central chapter provides a comprehensive examination of the Arbitrage Pricing Theory. It starts with Ross's original formulation, explaining its principles, assumptions, and mathematical representation. It then explores various interpretations and extensions of the APT, including traditional and equilibrium versions, and critically evaluates the empirical evidence supporting or refuting the theory. The identification and interpretation of macroeconomic factors are also key aspects of this chapter.
What is discussed in the chapter on "Arbitrage valuation of risky income streams"?
This chapter focuses on the practical application of APT in asset valuation. It contrasts traditional valuation methods with those incorporating APT, providing detailed explanations of the general arbitrage approach and potentially exploring innovative techniques such as binomial option pricing models within the context of arbitrage theory. A comparison of different approaches highlights their respective advantages and disadvantages.
What are the key limitations of the Capital Asset Pricing Model (CAPM) as discussed in the preview?
While not explicitly detailed, the preview implies that the limitations of the CAPM, such as its simplifying assumptions and potential inconsistency with empirical observations, motivate the exploration of the Arbitrage Pricing Theory (APT) as a more robust alternative.
What is the significance of macroeconomic factors in the context of the APT?
The preview suggests that understanding and interpreting macroeconomic factors is crucial for applying the APT effectively in real-world scenarios. These factors likely influence asset returns and need to be considered in any practical application of the theory.
What are some of the key keywords associated with this document?
Keywords include Arbitrage Pricing Theory (APT), Capital Asset Pricing Model (CAPM), Asset Pricing, Valuation, Risk, Return, Portfolio Theory, Factor Models, Arbitrage, Equilibrium, Macroeconomic Factors, Empirical Evidence, and Option Pricing.
What is the overall objective of this document?
The document aims to provide a comprehensive exploration of the Arbitrage Pricing Theory (APT) as an approach to capital asset valuation, examining its development, empirical support, and practical applications in various valuation methods.
- Arbeit zitieren
- Dr. Christian Koch (Autor:in), 1996, The Arbitrage Pricing Theory as an Approach to Capital Asset Valuation, München, GRIN Verlag, https://www.grin.com/document/123089
