Arbitrage Pricing Theory (APT) Advantages and Disadvantages – also explain its Meaning, Importance, Benefits, Assumptions Pros, Limitations, and Cons. Arbitrage Pricing Theory (APT) Essay is a pricing model based on the concept that an asset can produce predictable results. To do this, it is necessary to analyze the relationship between assets and their risk factors as a whole. APT was first developed in 1976 by Stephen Ross to study the influence of macroeconomic factors. In this way, both the return on the portfolio and the return on a particular asset can be predicted by examining the various independent variables in the relationship.
Here is the article to explain, Arbitrage Pricing Theory (APT) and its main points of Meaning, Importance, Benefits, Assumptions, Pros, Advantages, Cons, Limitations, and Disadvantages.
What are the major advantages and disadvantages of APT (arbitrage pricing theory)? It is based on the idea that in a properly functioning securities market there should be no arbitrage available. This makes it possible to predict the outcome of this certainty over a longer period of time. What is meant by Arbitrage Pricing Theory (APT)? The name itself is a suggestion of theory and what it does. This is the mechanism by which investors identify specific assets. Imagine participation at the wrong price. Investors can lower share prices by knowing the value they hold. So, without a doubt, APT can be said to be one of the most important mechanisms that should be used. Why we need to know the underlying advantages, importance, benefits, assumptions, limitations, disadvantages of arbitrage pricing theory (apt) as to give below.
Why is the importance of arbitrage pricing theory?
It is a theory that helps investors and analysts find the right structure and multi-pricing model for asset security based on the relationship that assets have expected returns to risk (watch in youtube). In particular, the theory does its job, which states that a security’s fair market price may not be determined correctly. The main assumption of this theory is that market action is becoming less and less effective and perfect.
Therefore, it can be said that the pricing of acquired assets was not carried out correctly. Or the asset is over-or undervalued, which can cause problems during this period. But here too, market action should ultimately be able to remedy the whole situation or problem where the asset price returns to a fair market condition.
For arbitration, the wrongly valued property securities represent a short-term opportunity for the realization of a practical gain, and this too without any particular risk. When we talk about APT flexibility or arbitrage pricing theory, it can be said that APT flexibility is little more than the stock model or CAPM. In addition, APT is proving to be a very complex alternative to the CAPM option.
It is a theory that provides investors and analysts with the ability to adapt any research that carries out on the market, as well as assets. However, applying this theory is a little more difficult than you can imagine, and also takes a long time. It may take some time to determine the risk factors that could affect the price of the asset in question.
Arbitrage Pricing Theory (APT) explain its Benefits.
Now that you know more about this theory; let’s move on to some of the other important passages that may interest you. Why do you think this model is so popular with investors? Here we will discuss why this model is so important. So you have to read it to the end to understand what we are talking about. Arbitrage pricing theory is an asset pricing theory that measures the expected return on an asset as a linear function of various factors.
The reason APT sees this as a revolutionary idea is that users can easily adapt this model to analyze the best security. There are several other pricing models on the market to help investors decide the value of securities. Nothing works as well as this theory and pricing model. Apart from that, APT is also very useful in building portfolios because with the help of this manager you can easily test the portfolio exposure factors.
What are the assumptions in arbitrage pricing theory?
Arbitrage pricing theory works with a pricing model that takes into account many sources of risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM); which only takes into account one factor for the level of risk in the market as a whole; the APT model takes into account several macroeconomic factors that theoretically determine the risk and return of a particular asset.
These factors provide a risk premium to investors that need attention; because they involve the systemic risk that diversification cannot eliminate. APT offers investors the opportunity to diversify its portfolio; but, also to select individual risk and return profiles based on premiums and sensitivity to macroeconomic risk factors. The venture investor will take advantage of the difference between the expected and actual returns on assets using arbitrage.
To understand APT we need to study the basic assumptions of arbitrage pricing theory as given below.
- This theory is based on the principle of capital market efficiency; and, therefore assumes that all market participants act to maximize profits.
- It assumes that there is no arbitrage and when that occurs; participants commit to taking advantage of it and bringing the market back to equilibrium.
- The market assumes to be smooth; H. No transaction fees, no taxes, you can short sell, and the number of shares to choose from is unlimited.
Pros of arbitrage pricing theory.
We need to study the main pros or advantages of arbitrage pricing theory as given below.
- The APT model is a multi-factor model. Therefore, the expected return is calculated by taking into account the various factors and their sensitivities that can affect stock price movements. In this way, the factors that have a strong influence on the stock price can be selected.
- The APT model is based on assumptions of arbitrary price or market equilibrium which, to some extent, leads to reasonable expectations of returns on risk-weighted assets.
- In contrast to CAPM, the basic multi-factor model emphasizes the covariance between return on assets and exogenous factors. CAPM emphasizes the covariance between return on assets and endogenous factors.
- The APT model works better in cases with multiple periods than the CAPM, which is only suitable for cases with one period.
- APT can apply to capital expenditures and capital budget decisions.
- The APT model does not require assumptions about the empirical distribution of returns on investment, unlike CAPM, which assumes that returns on equity follow a normal distribution and therefore APT is a less restrictive model.
Cons or Drawbacks or Limitations of Arbitration Pricing Theory.
We need to study the main disadvantages or cons or drawbacks or limitations of arbitrage pricing theory as given below.
- The model requires a shortlist of the factors that affect the inventory in question. Finding and listing all the factors can be a difficult task and you run the risk of ignoring several others. There may also be a risk that random correlation could cause a factor to be a supplier to have a significant impact or vice versa.
- The expected rate of return for each of these factors must achieve, which depends on the nature of the factor may or may not always be available.
- Such a model requires calculating the sensitivity of each factor, which in turn can be a difficult and possibly impracticable task.
- The factors that affect the stock price of a particular share can change over time. In addition, the associated sensitivity may fluctuate which must continuously monitor, which makes computation and maintenance extremely difficult.
Advantages of APT (arbitrage pricing theory).
We need to learn the underlying advantages of arbitrage pricing theory as gives below.
Allow more sources of risk.
APT allows multiple risk factors to include in the data set, rather than excluding them. That way, individual investors can gain more information about why some stock returns move in certain ways. This eliminates many of the movement problems left by other theories because the data set contains more sources of risk.
Allows unexpected changes.
APT is based on the idea that no surprises will happen. These are unrealistic expectations, so Ross adds equations to support the unexpected change. This makes it easier for investors to identify the asset with the greatest potential for growth or default based on the information provided by the opportunity itself.
There are fewer restrictions.
APT does not have the same portfolio requirements as other forecast theories. In addition, there are fewer restrictions on the types of information a prediction can fulfill. Because more information is available with less general limitations, the results with arbitrage pricing theory are more reliable than those of competitors’ models.
No special factors give.
Although APT, like other pricing models, does not offer specific factors, in theory, it takes into account four important factors. APT takes into account changes in inflation, changes in industrial production, changes in the risk premium, and changes in interest rate structure when factoring in long-term forecasts.
Allows investors to find arbitrage opportunities.
APT’s goal is to help investors spot stocks in a market that have been misjudged in some way. Once they can identify, it becomes possible to build a portfolio based on them to produce better returns than the index offers. If the portfolio undervalues, changes in pricing theory can turn opportunities into profits.
Disadvantages of APT (arbitrage pricing theory).
We need to learn the underlying disadvantages of arbitrage pricing theory as gives below.
Requires that the source of the risk is correct.
Each portfolio exposes to a certain level of risk. To be of use to APTs, investors must have a clear understanding of the risks and sources of these risks. Only then can this theory consider a reasonable estimate of factor sensitivity with greater accuracy? If there is no clear definition of the source of risk, there are more potential outcomes that reduce the effectiveness of the predictive quality provided by APT.
Requires that the portfolio view separately.
APT is only useful when examining one element of risk. Because of this feature, it is almost impossible to examine an entire portfolio with a large number of assets. Therefore, the entire portfolio examines using arbitrage pricing theory. Since not every account but only the portfolio report, certain assumptions must make in the valuation. This can create uncertainties that reduce the accuracy of the analyzed results.
A large amount of data generate.
For a person unexpected with arbitrage pricing theory, the number of statistics to sort via can experience overwhelming. This information generates through a specific analysis of the various factors that cause growth or loss so that prognostic quality can be a factor in portfolio decision making. A person unfamiliar with the purpose of each data point will not understand the results APT produces, making it a useless tool for them.
This is not a guarantee of results.
The arbitrage pricing theory does not guarantee that a profit will be made. Currently, several securities in the market undervalue for reasons beyond APT’s scope. Some risks are not “real” risks because they instill by investors themselves in pricing mechanisms, who have certain fears of certain securities under certain market conditions.
The pros and cons of arbitrage pricing theory aim to look at long-run average returns. Several systematic influences can affect this long-term average. By studying the assets and risks involved, it is possible to predict the expected rate of return. This is a great option for individual securities. However, when examining a portfolio of different securities, APT may not be the right tool.