The Strengths Of The Arbitrage Pricing Model

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Alternative Asset Pricing Models
Arbitrage Pricing Theory (APT) was developed by Stephen Ross (1976) as an alternative model to overcome some of the weaknesses that have been found in the CAPM. The APT is based on the Law of One Price. This means that if two assets have the same risk, theoretically they should have the same expected returns. If their expected returns differ, arbitrageurs would be able to create a long-short trading strategy that would have no initial cost, but would provide profits. Ross took a multifactor approach to explain the pricing of assets. The intuitive idea behind the APT is that asset prices are formulated by several factor prices, which have some fundamental and plausible relationship to the underlying company
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This is also known as the risk free rate. F1 and F2 are factors that affect the prices of stock i, and bi1 and bi2 are the degree to which the factors affect returns from the stock. These are the betas and there are separate beats for each of the factors. The final term ei, is an error term. The multi factor model is not very different. This equation is simply extended to include multiple factors with their respective betas. In APT, there is as many betas as there are factors that affect the price of the security. However, empirical work suggests that a three or four factor model adequately captures the influence of systematic factors on stock market returns. Richard Roll and Stephen Ross (1984) have identified the following four factors as being the most …show more content…
One of the main benefits is that investors can target different levels of expected return more accurately. This is possible as investors can choose to weight their portfolios in a way that offers them more or less exposure to each of the specific risk factors. Another key function of the Fama and French model is that is allows investors to categorise mutual funds by size and value and hence judge their expected return premium given the assets held. The model also allows fund managers and management to be evaluated more accurately. The TFM shows that a positive alpha in a CAPM regression is generally due to exposure to either SMB or HML factors, instead of actual manager performance. Whereas, with the TFM a reliable measure of alpha can be observed. A positive measure of alpha with the TFM would suggest that the mutual fund manager is adding value to the portfolio, beyond simply dividing invesments to produce varying degrees of exposure to the three risk factors. Finally, the Fama French model explains more of the variation in asset returns, exhibiting R2 values of 0.95 and higher. (Womack and Zhang,

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