13-05-2014, 04:30 PM
Arbitrage Pricing Theory
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Arbitrage:
Arbitrage is a process of earning profit by taking advantage of differential Pricing for the same asset.The process generates riskless profit.
In the security market, it is of selling security at a high price and the simultaneous purchase of the same security at a relatively lower price.
Since the profit earned through arbitrage is riskless, the investor have the incentive to undertake this whenever an opportunity arises.
However the buying and selling activities of the arbitrageur reduces and eliminates the profit margin, bringing the market price to the equilibrium level.
Assumptions of APT
Investors share homogeneous of expectations.
The investor are risk averse and utility maximizes.
Perfect competition prevails in the market and there is no transaction cost.
Arbitrage Portfolio
According to the APT theory an investors tries to find out the possibility to increase return from his portfolio without increasing the funds in the portfolio.
He also likes to keep the risk at the same Level.
For example: The investors holds A, B and C securities and he wants to change the proportion of the securities without any additional financial commitment. Now the change in proportion of securities can be denoted by XA, XB and XC.
Difference between APT & CAPM
APT is more general and less restrictive than CAPM. In APT , the investor has no need to hold the market portfolio because it does not make use of the market portfolio concept.
The portfolios are constructed on the basis of the factors to eliminate arbitrage profit. APT is based on the law of one price to hold for all possible portfolio combinations.
The APT model takes into account of the impact of numerous factor on the security. The micro-economic factors are taken into consideration and it is closer to reality than CAPM.