BFM 4283 : Arbitrage Pricing Theory

• Stephen Ross developed the Arbitrage Pricing Theory (APT) model in 1976, building upon the work of Harry Markowitz in 1952 and William Sharpe in 1964 with the Capital Asset Pricing Model (CAPM).
• The CAPM was developed based on a set of limiting assumptions, creating a restricted framework similar to the world depicted in the first Star Wars movie where Luke Skywalker was trapped in the garbage disposal with walls closing in.
• Despite its limitations, the CAPM provided valuable knowledge and wisdom in 1964, setting a strong foundation for further developments in financial risk management.
• The APT model by Stephen Ross expanded on the principles of the CAPM, offering a more comprehensive understanding of risk and return dynamics in financial markets.
• Ross's contribution in 1976 added significant value to the field of risk management, building upon the groundwork laid by Markowitz and Sharpe in earlier years.- The discussion revolves around the Arbitrage Pricing Theory (APT) as an asset pricing model for determining the reasonable required rate of return on a share of stock.
• APT is considered a natural extension, not an alternative, to the Capital Asset Pricing Model (CAPM).
• APT was developed to address the limitations of CAPM, offering a more flexible approach by incorporating multiple factors to assess systematic risk.
• The model uses linear relationships and factors like inflation, interest rates, GDP, and exchange rates to capture systematic risk.
• APT's founders, including Stephen Ross, William Sharpe, and Harry Markowitz, were economists with PhDs, emphasizing its economic foundation.
• APT does not assume a normal distribution of asset returns, acknowledging the presence of skewness and kurtosis in returns.
• APT allows for the use of multi-factor models like macro factor models, fundamental factor models, and statistical factor models to better predict required returns.
• A key aspect of APT is the use of factor loadings to hedge against systematic risk, allowing investors to create a zero beta portfolio by taking opposite positions.
• The model calculates a revised expected return by considering the differences between expected and actual factors' values and adjusting the initial expected return accordingly.
• APT's approach to using multiple factors and factor loadings provides a more comprehensive understanding of asset pricing and risk management compared to the single-factor model of CAPM.- Loss of 15 units during the first six or seven months of 2022, leading to a need for recovery.
• Hedging with multi-factors can help retain, lessen, or increase exposure to systematic risk.
• Illustration provided with an investor portfolio having GDP beta of 0.4 and consumer sentiment beta of 0.2.
• Combining the original portfolio with a short position in the GDP factor portfolio for hedging.
• Continuous monitoring required for hedging strategies due to tracking error and model risk.
• Fama and French introduced a three-factor model considering size, value, and market factors.
• Small firms tend to outperform larger firms due to less public information available.
• Differentiation between growth and value firms based on book-to-market ratios in the model.
• Expected return on a portfolio calculated using a weighted average of risk premiums.
• Portfolio alpha calculated as any return different from the expected return.

Test your knowledge on the differences and applications of the Arbitrage Pricing Theory (APT) model by Stephen Ross and the Capital Asset Pricing Model (CAPM) developed by Harry Markowitz and William Sharpe. Explore how APT expands upon CAPM's principles to offer a more comprehensive understanding of risk and return dynamics in financial markets.