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
3.2 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
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
5. Conclusion - some insights from the investment community
Objectives and Topics
This thesis examines the Arbitrage Pricing Theory (APT) as a robust framework for capital asset valuation, contrasting it with traditional models like the Capital Asset Pricing Model (CAPM). It aims to derive the fundamental principles of the APT, explore its empirical testability, and demonstrate its practical utility in valuing risky income streams and investment projects.
- Comparison between CAPM and APT paradigms
- Derivation of the Arbitrage Pricing Theory and the k-factor return generating process
- Analysis of empirical evidence supporting the APT and its factor identification
- Integration of arbitrage theory into modern valuation processes (DCF and real options)
Excerpt from the Book
3.1.1.1 Absence of arbitrage
The arbitrage argument is the most powerful tool in positive financial economics. “Most of modern finance is based on either the intuitive or the actual theory of the absence of arbitrage. In fact, it is possible to view absence of arbitrage as the one concept that unifies all of finance.” Its central idea is straightforward: if no arbitrage opportunities exist then perfect substitutes in (perfect) financial markets must have the same price. The law of one price is an immediate implication of the absence of arbitrage (without being equivalent). Dybvig and Ross (1989) provide a working definition of arbitrage:
“An arbitrage opportunity is an investment strategy that guarantees a positive payoff in some contingency with no possibility of a negative payoff and with no net investment. By assumption, it is possible to run the arbitrage possibility at arbitrary scale [...].”
Formally, an arbitrage opportunity is defined as a portfolio represented by a n-vector xn^T = {x1,x2,...,xn}, where each of the components xi is the money amount invested in asset i as a fraction of total wealth, such that:
(E.6) xn^T en = 0, meaning the portfolio xn is costless, and
(E.7) var(xn^T rn) = 0, portfolio xn has no risk (measured by variance), and
(E.8) E(xn^T rn) > 0, the expected (certain) return is positive.
Summary of Chapters
1. Introduction: Presents the APT as a traceable framework for understanding the relationship between risk and return and outlines the paper's goal of linking APT principles to the valuation of risky income streams.
2. Overview of asset pricing in modern capital market theory: Reviews the CAPM, its assumptions, major implications like the CML and SML, and discusses its limitations and empirical critiques.
3. The Arbitrage Pricing Theory: Derives the APT based on the absence of arbitrage and the linear k-factor model, classifies various APT contributions, and assesses empirical evidence and factor identification.
4. Arbitrage valuation of risky income streams: Links APT principles to valuation techniques, including DCF approaches and innovative methods like the general arbitrage and binomial option pricing approaches.
5. Conclusion - some insights from the investment community: Summarizes the role of APT as a complement to CAPM in investment management and highlights its potential for broader future application.
Keywords
Arbitrage Pricing Theory, APT, Capital Asset Pricing Model, CAPM, Asset Valuation, Systematic Risk, k-factor model, Portfolio Diversification, Discounted Cash Flow, DCF, Real Options, Risk Premium, Market Equilibrium, Factor Loadings, Valuation Methods.
Frequently Asked Questions
What is the primary focus of this thesis?
The paper focuses on the Arbitrage Pricing Theory (APT) as an alternative to traditional asset pricing models, specifically examining its theoretical derivation and practical application in asset valuation.
What are the core themes covered?
Key themes include the fundamental principles of absence of arbitrage, the linear k-factor return generating process, empirical testability of the model, and its utility in corporate finance and project valuation.
What is the main goal of the research?
The objective is to provide a thorough overview of the APT, demonstrate how it functions as an instrument for capital asset pricing, and show how its principles can be linked to the valuation of risky assets.
Which scientific methods are applied?
The paper employs a theoretical derivation of the pricing formula combined with a review of existing empirical research and financial literature to compare models and provide valuation insights.
What does the main part of the work address?
The main part introduces the derivation of the APT, discusses factor models, reviews empirical evidence from capital markets, and analyzes the identification of macroeconomic factors.
Which keywords define this work?
Major keywords include Arbitrage Pricing Theory (APT), Capital Asset Pricing Model (CAPM), Systematic Risk, Factor Models, Portfolio Valuation, and Arbitrage.
How does the APT differ from the CAPM in its treatment of risk?
Unlike the CAPM, which reduces all systematic risk to a single market factor, the APT considers multiple systematic risk sources, making it a more flexible model for valuing various types of assets.
Can the APT be applied to non-marketed assets?
Yes, the thesis explicitly discusses how the arbitrage theory can be utilized to value non-marketed income streams, such as those in capital budgeting or M&A transactions, by treating them similarly to marketed securities.
- Quote paper
- Dr. Christian Koch (Author), 1996, The Arbitrage Pricing Theory as an Approach to Capital Asset Valuation, Munich, GRIN Verlag, https://www.grin.com/document/123089
