In Insolvency and Bankruptcy Board of India’s valuer exam, Arbitrage Pricing Theory (or APT) comes under Valuation Applications chapter that carry 35% weightage. Along with this, various set of asset pricing model are covered in this chapter, which are very important to understand for the purpose of clearing IBBI Registered valuer examination. You can expect 2 to 3 marks from APT in the IBBI registered valuer exam. In today’s blog we will discuss only regarding APT or Arbitrage Pricing Theory which is a general theory of asset pricing.

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns can be forecasted with the linear relationship of an asset’s expected returns and the macroeconomic factors that affect the asset’s risk. The theory was created in 1976 by American economist, Stephen Ross. The APT offers analysts and investors a multi-factor pricing model for securities, based on the relationship between a financial asset’s expected return and its risks.

The APT aims to pinpoint the fair market price of a security that may be temporarily incorrectly priced. It assumes that market action is less than always perfectly efficient, and therefore occasionally results in assets being mispriced – either overvalued or undervalued – for a brief period of time.

However, market action should eventually correct the situation, moving price back to its fair market value. To an arbitrageur, temporarily mispriced securities represent a short-term opportunity to profit virtually risk-free.

The APT is a more flexible and complex alternative to the Capital Asset Pricing Model (CAPM). The theory provides investors and analysts with the opportunity to customize their research. However, it is more difficult to apply, as it takes a considerable amount of time to determine all the various factors that may influence the price of an asset.

Assumptions in the Arbitrage Pricing Theory

The Arbitrage Pricing Theory operates with a pricing model that factors in many sources of risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM), which only takes into account the single factor of the risk level of the overall market, the APT model looks at several macroeconomic factors that, according to the theory, determine the risk and return of the specific asset.

These factors provide risk premiums for investors to consider because the factors carry systematic risk that cannot be eliminated by diversifying.

The APT suggests that investors will diversify their portfolios, but that they will also choose their own individual profile of risk and returns based on the premiums and sensitivity of the macroeconomic risk factors. Risk-taking investors will exploit the differences in expected and real returns on the asset by using arbitrage.

Arbitrage in the APT

The APT suggests that the returns on assets follow a linear pattern. An investor can leverage deviations in returns from the linear pattern using the arbitrage strategy. Arbitrage is the practice of the simultaneous purchase and sale of an asset on different exchanges, taking advantage of slight pricing discrepancies to lock in a risk-free profit for the trade.

However, the APT’s concept of arbitrage is different from the classic meaning of the term. In the APT, arbitrage is not a risk-free operation – but it does offer a high probability of success. What the arbitrage pricing theory offers traders is a model for determining the theoretical fair market value of an asset. Having determined that value, traders then look for slight deviations from the fair market price, and trade accordingly.

Mathematical Model of the APT

The Arbitrage Pricing Theory can be expressed as a mathematical model:

ER(X) = Rf+betaRP1 + Beta RP2 + ….. + Beta(n) RP (n)

Where:

ER(x) – Expected return on asset

Rf – Riskless rate of return

βn (Beta) – The asset’s price sensitivity to factor

RP(n) – The risk premium associated with factor

Historical returns on securities are analysed with linear regression analysis against the macroeconomic factor to estimate beta coefficients for the arbitrage pricing theory formula.

From this piece of information, you must have realised how intuitive appealing and easy to learn Arbitrage Pricing Theory is. This concept of APT is so relevant that at times in IBBI registered valuer exam questions come only from this topic alone for 3-4 marks. Therefore, Student’s unfamiliarity with asset pricing tools business strategies like CAPM, APT etc. assume that these areas are complex and they avoid studying them. But is it so? Are they really difficult to understand? I Do not think so! I would like to encourage you all to remove these misconceptions and embrace these theory areas. You can easily score those 3 or 4 marks in valuer examination that will make the difference between passing and failing.

What is eventually important for you is to study strategically and work on your weak areas with complete dedication so that you could pass the IBBI registered valuer examination. And for passing that examination with a minimum of 60% marks, these small and easy areas make a lot of difference. RVMOCKTEST.ONLINE is there to help you in this path of becoming a Registered Valuer by making you exam ready. You can check your preparedness and identify your mistakes, by appearing in online mock tests of RVMOCKTEST.ONLINE that will boost your confidence and increase your chances of clearing in one single shot!!

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