Question

Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that tests its validity

Answer 1

The Arbitrage Pricing Theory is a theory of asset pricing that holds that an asset's returns, can be forecasted with the linear relationship of an asset's expected returns and the macroeconomics factors that affects the asset' s risk .

The theory was created in 1986 by American economist , Stephen Ross . The APT offers analysts and investors a multi factor pricing model for Securities, based on the relationship between a financial asset's expected return and it's risks.

The APT aims to pinpoint the fair market price of a security that may be temporarily incorrectly priced. It assumes that market action is less than always perfectly efficient and therefore occasionally results in assets being mispriced- either overvalued or undervalued- fir a brief period of time.

However market action should eventually correct the situation, moving price back to its fair market value to an arbitrageur temporarily mispriced securities represent a short- term opportunity to profit virtually risk- free.

I take an empirical evidence of APT in the Japanese equity market using Japanese macroeconomics factors.

Factors exmined include

1. Industrial production

2. Inflation

3. Investor confidence

4. Interest rate

5. Foreign exchange

6. Oil price

These are chosen in view of a simple financial theory of asset pricing.

Our procedure allows us to examine the international robustness of theory and hence to compare the results with those for the U.S. Evidence of the risk premia on multiple factors is presented. Priced and non- priced factors in the Japanese economy are also discussed.

We further test the validity of the CAPM beta in this context. The result shows that the CAPM beta does not capture any extra risk that may have been missed by the macroeconomic factors.