Question

Critically evaluate the use of Arbitrage Pricing Theory (model) in asset pricing.

Answer 1

Answer

Arbitrage Pricing Theory (APT) facilitates the investors in estimating required rate of return on risky securities. This theory takes into account risk premium basis specific set of factors ( for example; rate of inflation, rate of exchange, market indices, fluctuations in interest rates, etc.) along with correlation of asset price with expected excess return on market portfolio.

The model based on Arbitrage pricing theory intends to wipe out the limitations of single or one-factor model (CAPM) .In other words it can be said that not all stocks can always be supposed to respond to a single and similar factor and therefore the requirement to take multifactor analysis and their reactions arises.

Use of arbitrage pricing theory in asset pricing

• This model permits selection of various factors that influence the stock price largely and particularly as it is a multifactor model. Therefore, expected return of securities is calculated after considering different factors and their sensitivities on stock price fluctuations.
• A fair rate of return on risky assets can be expected under this model as it is based on arbitrage free pricing or market equilibrium assumption.
• This multifactor model emphasises on the covariance between returns on assets and external or macro economic factors like rate of inflation, rate of exchange, market indices, fluctuations in interest rates, etc.
• It can better operate in multi-period cases so as to facilitate analysis and decision making.
• This model can be used for cost of capital and capital budgeting decisions where funds are employed for a long span of time.