Understand the Arbitrage Pricing Theory (APT) - Management Assignment Help

Assignment Task:

Task:

1. Preface

The purpose of this study is twofold. First, to understand the “Arbitrage Pricing Theory (APT)”and second to analyze how far is Beta (β) is valid and effective to quantify the security’s volatility in response to the macro-economic factors in comparison to the “Fama -French 3 factor model” (Faisal et al., 2018). “Arbitrage Pricing Theory” is not just about fancy ciphering. It has many aspects to it. Instead, arbitrage pricing theory is used to supplant the “Capital Asset Pricing Model (CAPM)”. Arbitrage Pricing Theory is a technical model that establishes an alliance between the expected return of the securities and its leverage factors (Elshqirat, 2019). An American Scientist instituted this theory, Steve Ross in the 1970s. The theory offers analysts and investors a multi-factor pricing paradigm for various financial assets. The two dimensions of APT theory is “Purchasing Power Parity Theory” and “Interest Rate Parity Theory”. The Mathematical Model of Arbitrage Pricing Theory is represented as:

“Expected Return of the Asset E(Rx) = Return of Risk-free asset (Rf)+β(Ra)+β(Rb)”………

“Where E(Rx) represents Expected Return

Where β represents financial assets sensitivity to that macroeconomic factor

Where Ra, Rb represents different types of securities”.

Arbitrage Pricing theory is preferred over Capital Asset Pricing Model for several reason. Although both the ideologies are based on linear regression analysis Arbitrage Pricing Theory takes into consideration the macro economic factors such as inflation rate, interest rates, level of production of industries, change in risk premium etc. (Nguyen et al., 2017). Fama – French Model which is based on Capital Asset Pricing Model adds Beta(β) to two other factors but this quantitative measure of two acts as a hindrance for study (Sattar, 2017). The above-mentioned model is represented as:

“Expected Return of the Asset E(Rx) = Return of Risk-free asset (Rf)+β1(Rm – Rf)+β2(SMB)+β3(HML)+?”

“Where E(Rx) represents Expected Return

Where β represents financial assets sensitivity to that macroeconomic factor

Where Rf represents yield on risk free securities

Where (Rm – Rf) represents market risk premium

Where SMB (Small minus Big) denotes surplus return of small cap companies over large cap companies

Where HML (High Minus Low) represents surfeit return of value stocks (high book to price ratio) over growth stock (low book to price ratio)

Where ? represents risk”

“Purchasing Power Parity Theory (PPPT)” is an economic cum financial metric for measuring the cost of a single commodity in different markets worldwide. It is a theory that compares various countries’ currencies through a “basket of goods” approach (Elshqirat, 2019). According to this theory commodities should be priced at par considering the exchange rates. In other words, no factors should influence the cost of commodities. Economists have found this theory useful for in-depth analysis of variance between the standards of living of different nations. There are two different facets to this philosophy one which is formed based on relative approach the other one being absolute. The arithmetical presentation of Purchasing Power Parity theory is:

“Forward Rate of Foreign currency (F)= Spot rate of Home currency(S)* (1+ rate of inflation of home currency/ 1+rate of inflation of foreign currency).”

The only significant pitfall of this model is that does not consider factors like import duties, transport costs, government intervention (tariffs), and the market's competitive nature.

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