1. Arbitrage Pricing Theory

2. In apt there are a no of industry specific and macro economic factors that affect the security’s return unlike CAPM where Beta is considered the most important single factor Investors indulge in arbitrage when they find differences in returns of assets with similar risk characteristics.

3. Return on asset=predictable component +unpredictable component E(Rj)=Rf+UR Rf=predictable return based on information available to investors ), UR=unanticipated part of return (future information=firm specific or market related) E(Rj)=Rf+URs+URm URs=unexpected component of return, specific factors related to firm URm= unexpected component of return, market related factors

4. Risk and APT Risk from firm specific factors- diversifiable= unsystematic risk Risk from market related factors - cannot be diversified= systematic risk Multi factor model unlike CAPM Market risk can be caused by many factors such as changes in GDP, inflation, interest rates Under APT sensitivity of the assets return to each factor is estimated.for each firm there are as many betas as no of factors E(Rj)=Rf +  1F1+  2F2+  3F3…..+  nFn) +URs

5. Steps for calculating expected return under APT 1.Searching for factors that affect the assets return- 2.Estimation of risk premium for each factor 3.Estimation of factor beta

6. Difference between CAPM & APT 1.CAPM has a single non-company factor and a single beta, whereas arbitrage pricing theory separates out non-company factors. Each of these requires a separate beta. The beta of each factor is the sensitivity of the price of the security to that factor.

7. Difference between CAPM & APT 2.APT does not rely on measuring the performance of the market. it directly relates the price of the security to the fundamental factors driving it. The problem with this is that the theory in itself provides no indication of what these factors are, so they need to be empirically determined..

8. Difference between CAPM & APT The potentially large number of factors means more betas to be calculated. There is also no guarantee that all the relevant factors have been identified. This adds complexity - reason arbitrage pricing theory is far less widely used than CAPM

9. Example Suppose that GNP, inflation, interset rate, stock market index and Industrial production affect the share return of the firm ABC ltd You hav einformation about the forecasts and actual values of the factors, firms GNP beta, inflation Beta etc Investor wants to invest in ABC

10. FactorBeta Expected value(%) Actual Value(%) GNP1.9566.5 Inflation0.8555.75 interest rate1.278 Stock market index2.59.511.5 industrial production2.2910

11. Total return on share= anticipated return + unanticipated return Anticipated return= effects of known information such as expected inflation and other factors To determine the surprise part in systematic factors? Difference between expected and actual values of the factors =Surprise  shareholders to be compensated for this This difference multiplied by the factor beta will compensate the shareholders for factors systematic risk Expected value of the factor is the risk free part