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Essay sample on Arbitrage pricing theory

Arbitrage pricing theory

Arbitrage pricing theory is a concept that is applied in the financial sector. This theory is an approach that is used in determining the value of various assets depending on the law of one price without arbitrage. It is a multi-factor model for asset pricing that is derived from a statistical model in which the CAPM is used as the asset pricing model for the equilibrium. This theory operates on the assumption that the return on assets is based on various macro-economic, security and market-specific aspects.

The general idea behind the Arbitrage Pricing theory is that two things can be used in giving the explanation of the expected return on financial asset. These two things include the macroeconomic or security-specific influences and the sensitivity of the assets to those influences. This kind of relationship can take the form of linear regression formula. It should be noted that there are an infinite number of influences that are security-specific for every security like production measures, inflation, exchange rates, market indices and investor confidence. The choice of the relevant influences rests with the analyst.

When using the APT, it is very important that you also get to know about some of the assumptions of the approach in order to make the work easier. One of the assumptions is that all securities have got finite values and variances that are to be expected. Besides, there are chances that certain agents can form portfolios that are well diversified. It should also be noted when using this approach that there are no taxes and transaction costs.

Using the APT model, an analyst can derive the expected rate of return on an asset. After doing this, the analyst can decide to even move further and determine what the ideal price of the asset should be through plugging the rate into a cash flow model that is discounted. With this kind of provision, it makes it possible for the Arbitrage pricing theory to be applied to individual securities and portfolios. Bear in mind that a portfolio can be exposed and sensitive to particular kinds of risk factors too.

You may be asking yourself why the Arbitrage pricing theory is important. This approach was a revolutionary model since it enables the user to adapt it to the security that is under analysis. Compared to the other pricing models used in the market, the APT helps the analyst in making a decision on whether the value of a security has been under estimated or overestimated. This information can be very profitable to the analyst since he or she is able to know the expected figures in advance and find a way of how to get the most out of the deal.

Arbitrage pricing theory is an important tool that can also be useful in building portfolios since it offers managers an opportunity to conduct testing on whether their portfolios are exposed to particular factors. This approach may be more customizable and a little challenging considering the amount of research that is required.

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