Arbitrage Pricing Model

Arbitrage Pricing Model

Arbitrage pricing model (APM) is a financial model used in portfolio management that attempts to explain the relationship between the expected returns of a financial asset and the underlying macroeconomic variables that influence those returns. The model assumes that an asset’s expected returns are determined by multiple factors, and that these factors are priced into the asset’s price. By identifying and quantifying these factors, investors can assess whether an asset is overvalued or undervalued and make informed investment decisions.

The APM is based on the concept of arbitrage, which is the practice of taking advantage of price differences between two or more markets to make a profit. In the context of portfolio management, the APM assumes that there are no arbitrage opportunities in the market, meaning that all assets are priced efficiently according to their underlying risk factors. If an asset is mispriced, investors would buy or sell the asset until its price reflects its true value, eliminating any arbitrage opportunities.

The APM is a useful tool for portfolio managers because it allows them to identify the specific factors that are driving an asset’s returns and adjust their portfolio accordingly. By identifying assets that are undervalued or overvalued based on their underlying risk factors, investors can make more informed investment decisions and potentially achieve higher returns with lower risk. However, the APM is not a perfect model, and there are limitations to its ability to predict future returns. Nonetheless, it remains a valuable tool for investors looking to optimize their portfolio

Arbitrage – arises if an investor can construct a zero investment portfolio with a sure profit. Since no investment is required, an investor can create large positions to secure large levels of profit. In efficient markets, profitable arbitrage opportunities will quickly disappear. In APT, there are 3 major assumptions.

• Capital markets are perfectly competitive and no transaction cost. This assumption makes possible the arbitraging of “mispriced” securities, thus forcing an equilibrium price.
• Investors always prefer more wealth to less wealth.
• Various factors give rise to returns on securities and the relation between the security return and that these factor is LINEAR. The stochastic process generating asset returns can be expressed as a linear function of a set of K risk factors or indexes.

 

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