With arbitrage pricing theory, we can calculate the price of investment which is developed Stephen Ross in 1976. APT is based on the expected return of a financial asset.
According to APT
Asset Price = Expected price at discount rate
APT Model
Risky Asset Returns =
Expected Asset’s return + No. of times Sensitivity of Assets X Systematic Factor
In arbitrage pricing theory, it is assumed that there are two person in financial market one is arbitrageur and other investor. Arbitrageur plays two way business game of sale and purchase of assets. He sells high rate assets and purchases low rate assets. The arbitrageur is thus in a position to make a risk-free profit under APT.
Arbitrage in Expected Returns
Suppose you observed the following conditions:
1. Risk-free bonds may be purchased at a cost of $100 (or in fractions if required). They are known to pay off in one year $110 with certainty.
2. All investors can borrow and lend at the riskless rate.
3. Shares of the market portfolio may be purchased for $100 each. They are expected to pay off $120 at the end of the year, but there is uncertainty involved. Shares of the market may be purchased and shorted without transactions costs.
4. Shares of asset A may be purchased for $100 and they are expected by everyone to be worth $150 at the end of the year. Asset A has a beta of 1.3. As with the market, shares of A may be shorted and purchased without transactions costs.
According to APT
Asset Price = Expected price at discount rate
APT Model
Risky Asset Returns =
Expected Asset’s return + No. of times Sensitivity of Assets X Systematic Factor
In arbitrage pricing theory, it is assumed that there are two person in financial market one is arbitrageur and other investor. Arbitrageur plays two way business game of sale and purchase of assets. He sells high rate assets and purchases low rate assets. The arbitrageur is thus in a position to make a risk-free profit under APT.
Arbitrage in Expected Returns
Suppose you observed the following conditions:
1. Risk-free bonds may be purchased at a cost of $100 (or in fractions if required). They are known to pay off in one year $110 with certainty.
2. All investors can borrow and lend at the riskless rate.
3. Shares of the market portfolio may be purchased for $100 each. They are expected to pay off $120 at the end of the year, but there is uncertainty involved. Shares of the market may be purchased and shorted without transactions costs.
4. Shares of asset A may be purchased for $100 and they are expected by everyone to be worth $150 at the end of the year. Asset A has a beta of 1.3. As with the market, shares of A may be shorted and purchased without transactions costs.
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