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What is the Arbitrage Pricing Theory?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 21 July 2014
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    Conjecture Corporation
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One of the first things to understand about the arbitrage pricing theory is that the concept has to do with the process of asset pricing. Essentially, the arbitrage pricing theory, or APT for short, helps to establish the price model for various shares of stock. Here is some information about the arbitrage pricing theory, and why this concept is so helpful in determining the pricing model for the buying and selling of stock.

Developed by economist Stephen Ross in 1976, the underlying principle of the pricing theory involves the recognition that the anticipated return on any asset may be charted as a linear calculation of relevant macro-economic factors in conjunction with market indices. It is expected that there will be some rate of change in most if not all of the relevant factors. Running scenarios using this model helps to arrive at a price that is equitable to the anticipated performance of the asset. The desired result is that the asset price will equal to the anticipated price for the end of the period cited, with the end price discounted at the rate implied by the Capital Asset Pricing Model. It is understood that if the asset price gets off course, that arbitrage will help to bring the price back into reasonable perimeters.

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In practical application, the utilization of the arbitrage pricing theory can work very well when it comes to increasing the long term value of a stock portfolio. For example, the use of APT when the current price is very low would result in a simple process that would yield a return while still keeping the portfolio secure. The first step would be to shortsell the portfolio, then buy the low priced asset with the proceeds. At the end of the period, the low priced asset, which will have risen in value, would be sold and the proceeds used to buy back the portfolio that was recently sold. This strategy usually results in a modest amount of revenue for the investor.

A similar strategy is employed when the current price is high. With this set of circumstances, the investor would short sell the high priced asset and use the proceeds to buy the portfolio. At the end of the period, the investor would then sell the portfolio, use a portion of the proceeds to buy back the high priced asset and once again make a modes profit off the transaction.

The use of the arbitrage pricing theory is very common in the stock market of today. In some ways, the use of the theory is even more widespread than ever, since more investors have access to real time information via online methods than at any previous point in the history of trading. As a means of analyzing current conditions and responding accordingly, the arbitrage pricing theory has a solid record of performance, and will no doubt be employed by investors and analysts for many years to come.

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erumkhan
Post 1

What are the basic economic factors that are involved in APT??

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