The arbitrage theory of capital asset pricing Literature review

The arbitrage theory of capital asset pricing - Literature review Example At the same time, the risk factor offers price to investors for investing their money in risky securities. The sum total of both these factors gives a clear view regarding the expected rate of return on a particular asset. It is generally calculated by using a risk measure called beta. The arbitrage pricing theory is a well known alternative to capital asset pricing model that is beneficial for the investors to determine whether an asset is correctly priced or not. This paper tends to evaluate various aspects of the arbitrage theory of capital pricing. Structure of Arbitrage Pricing Theory Arbitrage Pricing Theory (APT) is an alternative to capital asset pricing theory and it is formulated by the economist Stephen Ross in 1976. In order to clearly evaluate the potentiality of arbitrage pricing theory, it is necessary to understand the range and terms of capital asset pricing model (CAPM). As discussed above, CAPM calculates rate of return of an asset by adding the value of risk taken with duration of investment. It is relevant to understand the working method of CAPM also. Assume that risk-free rate is 5%, the beta measure of the stock is 3 and the expected rate of market return for this period is 12%; then the expected rate of stock becomes: 5%+3(12% - 5%) = 26% In the opinion of Roll and Ross (1980), this theory had considerable significance in empirical work during the periods of 1960’s and 1970’s. However further researches on this concept have questioned its reliability and authenticity of the computation of empirical constellation of asset returns; and, many related theories have detected ranges of disenchantment with the CAPM (ibid). Authors say that this situation led to the demand for a more potential theory and it caused the formulation of APT. Although, APT was developed recently, CAPM is considered as the basis of modern portfolio theory. Huberman and Wang (2005) claim that both the CAPM and APT show relation between expected returns o f assets and their co-variance with other random variables; and an investor cannot avoid some types of risks by diversification and the concept of covariance is interpreted as a measure of such risks. While comparing with CAPM, the APT contains fewer assumptions; and at the same time, this theory is very difficult to use. Roll and Ross (1980) clearly tells that the basic idea behind arbitrage pricing theory is that the price of a security is varied by mainly two groups of factors such as macro factors and company specific factors. Since no ‘arbitrage assumptions’ are employed, this theory is popularly known in this name. The group categorization and thereby macro as well as company specific factors are very crucial to form the following formula: r = rf + ?1f1 + ?2f2 + ?3f3 + †¦ where r represents the expected rate on the security and rf is the risk free rate. In this formula, f stands for a separate factor and ? is a relationship measure between the security price and that factor. Cho, Eun, and Senbet (1986) have conducted an empirical investigation so as to evaluate the international performance of the arbitrage pricing policy. In their research, they mainly employed two valuation techniques such as inter-battery factor analysis and Chow test. The inter-battery factor analysis helped the authors to estimate the international common factors while they could test the validity of the APT using Chow test method. A