Question

In: Economics

2. (a) Explain carefully how stock returns are derived by arbitrage pricing theory (APT). (b) Briefly...

2. (a) Explain carefully how stock returns are derived by arbitrage pricing
theory (APT).
(b) Briefly evaluate the empirical performance of APT.

Solutions

Expert Solution

(a) Arbitrage pricing theory is an asset pricing model in which expected returns of an asset are modeled linearly as a function of various factors or market indices. Below is the relevant equation

All Xi refer to the different factors that explain the returns. The coefficients of the above equations are estimated by Ordinary least squares. slope coefficient indicate the sensitivity of each factor to the return on the asset. Once the model is estimated, the returns are derived with the help of the estimated model given the values of the above factors.

Under APT, if a stock if mispriced then its predicted price diverges from the actual price. Thus there are two possibilities:- either the stock is underpriced or overpriced. I show below the investment strategy when the stock is underpriced:
1. If the current price of the asset is too low then the investor can short-sell the portfolio and buy the underpriced asset.
2. At the end of the period, the mispriced asset is sold and the portfolio is bought back.
3. The difference between the two price is the profit.

(b) Roll and Ross (1980) conducted an empirical performance of APT. Over a period of 10 year, they studied daily returns for a sample of 1269 securities from NYSE and AMEX. They arranged them into 42 groups with 30 securities in each group. They then did maximum-likelihood factor analysis and used the estimated factor loading as explanatory variable in stage two of cross sectional regression test. They found that at least three factors constitute significant explanatory variable in the regression model. Huges (1981) and Chen (1983) identify five significant factors in the model structure.


Related Solutions

Describe an Arbitrage Pricing Theory (APT) model of your choice. How this model compares to the...
Describe an Arbitrage Pricing Theory (APT) model of your choice. How this model compares to the Capital Asset Pricing Model (CAPM)?             ii) Support your answers with empirical evidence on how well models you discussed in part (i) can explain variability of returns
Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that...
Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that tests its validity
Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that...
Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that tests its validity.
“The arbitrage pricing theory (APT) and capital asset pricing model(CAPM) are two major influential theories on...
“The arbitrage pricing theory (APT) and capital asset pricing model(CAPM) are two major influential theories on asset pricing. The APT differs from CAPM in that it is less restrict vein its assumptions. It allows for an explanatory (as opposed to statistical ) model of asset returns.” In terms of this quote, compare and contrast APT to CAPM. Your discussion should explain the assumptions,criticisms and advantages of each model as well as some of the common risk-factors uses in each model.
The arbitrage pricing model (APT) is a multi-risk factored asset pricing model that allows more than...
The arbitrage pricing model (APT) is a multi-risk factored asset pricing model that allows more than one risk factor to influence security prices”. In term of this statement, critically discuss the assumptions of the APT, its criticisms and its advantage over the CAPM. (In your answer provide a brief discussion on some of the common risk-factors used in APT).Subject is INVESTMENT
Can you please explain no pricing arbitrage theory for option pricing in detail? Take an example...
Can you please explain no pricing arbitrage theory for option pricing in detail? Take an example and do it excel. Please keep it neat and simple. Show all formulas in excel.  
Critically evaluate the use of Arbitrage Pricing Theory (model) in asset pricing.
Critically evaluate the use of Arbitrage Pricing Theory (model) in asset pricing.
explain briefly how the formulae of the Greeks may be derived from Black-Scholes option pricing model
explain briefly how the formulae of the Greeks may be derived from Black-Scholes option pricing model
2)   Discuss the shortcomings of the capital asset pricing model. How does the arbitrage pricing model...
2)   Discuss the shortcomings of the capital asset pricing model. How does the arbitrage pricing model address these shortcomings? Discuss the major shortcoming of the arbitrage pricing model? Explain which model is more useful in your opinion.
Briefly explain these two theories in pricing: Rounding Off Theory & Bargain Signaling Theory.
Briefly explain these two theories in pricing: Rounding Off Theory & Bargain Signaling Theory.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT