Arbitrage Pricing Theory.docx

# Arbitrage Pricing Theory.docx - Arbitrage Pricing Theory...

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Arbitrage Pricing Theory Arbitrage Pricing Theory (APT) is an alternate version of Capital Asset Pricing Model (CAPM) . This theory, like CAPM provides investors with estimated required rate of return on risky securities. APT considers risk premium basis specified set of factors in addition to the correlation of the price of the asset with expected excess return on the market portfolio. As per assumptions under Arbitrage Pricing Theory, return on an asset is dependent on various macro-economic factors like inflation, exchange rates, market indices, production measures, market sentiments, changes in interest rates, movement of yield curves etc. The Arbitrage pricing theory based model aims to do away with the limitations of one-factor model (CAPM) that different stocks will have different sensitivities to different market factors which may be totally different from any other stock under observation. In layman terms, one can say that not all stocks can be assumed to react to single and same parameter always and hence the need to take multifactor and their sensitivities. Calculating Expected Rate of Return of an Asset Using Arbitrage Pricing Theory (APT) Arbitrage Pricing Theory Formula – E(x) = rf + b1 * (factor 1) +b2 *(factor 2) + ….+ bn *(factor n) Where, E(X) = Expected rate of return on the risky asset

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• Summer '16
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