Background
Arbitrage Pricing Theory (APT) is a fundamental concept in financial economics that was formulated as an alternative to the Capital Asset Pricing Model (CAPM). The theory offers a multifactor approach to asset pricing and seeks to predict the return of an asset taking into consideration its exposure to various macroeconomic and microeconomic factors.
Historical Context
The Arbitrage Pricing Theory was introduced by economist Stephen Ross in 1976. It emerged during a period when financial economists were debating the efficiency of markets and the accuracy of prevalent asset pricing models. CAPM, which ruled prior to APT, was criticized for its reliance on a single market factor. APT addressed these limitations by allowing for multiple factors, capturing a broader spectrum of risks associated with asset prices.
Definitions and Concepts
Arbitrage Pricing Theory posits that the return of an asset is linearly related to multiple systematic risk factors through an equation that can be expressed as:
\[ E(R_i) = R_f + \beta_{i1}F_1 + \beta_{i2}F_2 + … + \beta_{in}F_n \]
Where:
- \( E(R_i) \) is the expected return of asset \( i \).
- \( R_f \) is the risk-free rate.
- \( \beta \) represents the asset’s sensitivities (factor loadings) to various fundamental factors \( (F_1, F_2, …, F_n) \).
An arbitrage opportunity arises when discrepancies between the expected return (based on these factors) and the actual return exist.
Major Analytical Frameworks
Classical Economics
Classical economics does not delve into arbitrage pricing theory explicitly but offers a foundational understanding of equilibrium and market efficiencies, which are crucial for arbitrage to be effective.
Neoclassical Economics
Neoclassical economics underlines the efficiency of markets and the role of rational actors, both of which are core presuppositions of the APT.
Keynesian Economics
While Keynesian economics centers on short-term economic fluctuations and aggregate demand, understanding these perspectives is essential to identify the macroeconomic factors influencing asset prices under APT.
Marxian Economics
Marxian Economic theory provides a critical lens for understanding the systemic risks related to capital, labor, and production, but it does not directly contribute to the principles of APT.
Institutional Economics
Institutional economics underscores the importance of regulatory frameworks and institutions that can affect market functions and the practical application of arbitrage.
Behavioral Economics
Behavioral economics highlights the potential anomalies and irrational behaviors in markets that might interfere with the standard operations of arbitrage indicated in APT.
Post-Keynesian Economics
Post-Keynesian economics focuses on uncertainty and capital markets, providing an understanding of risk perspectives not typically covered in APT.
Austrian Economics
Austrian Economics criticizes the theoretical underpinnings of some models like APT, arguing for the role of entrepreneurial discovery in asset pricing.
Development Economics
Development economics can offer insights into the specific risk factors relevant in emerging markets, aligning with the concept of factor loadings in APT.
Monetarism
Monetarism emphasizes the role of money supply and inflation as primary risk factors, which can be incorporated into APT’s multifactor approach.
Comparative Analysis
Case Studies
Suggested Books for Further Studies
- “Theory of Financial Decision Making” by Jonathan E. Ingersoll
- “Essentials of Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus
- “Modern Portfolio Theory and Investment Analysis” by Edwin J. Elton, Martin J. Gruber, Stephen J. Brown, and William N. Goetzmann
Related Terms with Definitions
- Arbitrage: The practice of taking advantage of a price difference between two or more markets.
- Beta Coefficient: A measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors.
- Capital Asset Pricing Model (CAPM): A model that describes the relationship between the systemic risk of a security and its expected return.
