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Questions and Answers
What is the primary assumption of the Arbitrage Pricing Theory (APT)?
According to the APT, what are the two things that can explain the expected return on a financial asset?
Who developed the Arbitrage Pricing Theory (APT) in 1976?
What is the formula for the Arbitrage Pricing Theory (APT)?
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What are some examples of security-specific influences in the APT?
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What is the purpose of analyzing the relationship between an asset and its common risk factors in the APT?
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What is the APT an alternative to?
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What does 'bj' represent in the APT formula?
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Study Notes
Arbitrage Pricing Theory (APT)
- APT is a method for estimating the price of an asset, assuming an asset's return is dependent on various factors.
- The theory was first created by Stephen Ross in 1976 to examine the influence of macroeconomic factors.
Factors Affecting Asset Return
- Macroeconomic factors
- Market factors
- Security–specific factors
APT Formula
- The APT formula is an alternative to the Capital Asset Pricing Model (CAPM).
- The formula is: E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 +...+ bjnRPn
- Where:
- E(rj) = the asset's expected rate of return
- rf = the risk-free rate
- bj = the sensitivity of the asset's return to the particular factor
- RP = the risk premium associated with the particular factor
Security-Specific Influences
- There are an infinite number of security-specific influences for any given security, including:
- Inflation
- Production measures
- Investor confidence
- Exchange rates
- Market indices
- Changes in interest rates
- The analyst must decide which influences are relevant to the asset being analyzed.
Pricing
- Once the expected rate of return of an asset is derived from the APT theory, the correct price of the asset can be determined.
- APT can be applied to portfolios as well as individual securities.
- A portfolio can have exposure and sensitivities to certain kinds of risk.
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Description
Learn about the Arbitrage Pricing Theory (APT), a method for estimating asset prices, and its key factors, including macroeconomic, market, and security-specific influences.
