Lecture Notes 6 APT - The Arbitrage Pricing Theory(APT A...

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1 The Arbitrage Pricing Theory (APT) A basic principle of financial economics: In efficient markets, prices must be such as to rule out the existence of arbitrage opportunities APT is an asset pricing model which relies on the "no arbitrage" principle to generate pricing restrictions which must hold for well-diversified portfolios.
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2 Key Assumptions Security returns are generated by one or more factors Examples of macroeconomic factors are: unanticipated inflation interest rate shock unanticipated change in GNP
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3 The one factor version i e F i i r E i r ~ ~ ) ( ~ + + = β where E(r i ) = the expected return F = deviation of factor from its expected value β i = sensitivity of security i's return to the factor e i = idiosyncratic component of the return
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4 Key statistical assumptions • E(e i |F) = 0 – E(e i ) = 0, for all i • Cov(e i , e j ) = 0, for all i , j E(F) = 0
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5 Result: One factor APT For a large, well-diversified portfolio ‘P’: F r E r p p p ~ ) ( ~ β + =
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Lecture Notes 6 APT - The Arbitrage Pricing Theory(APT A...

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