This paper focuses on common stock returns governed by a formula structure; the APT is a one-period model, in which avoidance of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. A comparison has been performed along the lines of Chen (1983). This comparison portrayed that APT to perform better than CAPM in explaining the differences.

INTRODUCTION

Asset prices are universally believed to react sensitively to economic news. Every day experience seems to carry the view that individual asset prices are influenced by a broad variety of unpredictable events and that some events have a more pervasive outcome on asset prices than do others (Chen et al., 1986). Thus, various asset pricing models can be used to determine equity returns.

Investopedia.com defines arbitrage pricing model as an asset pricing model using one or more common factors to price returns. It is called a single factor model with only one factor, representing the market portfolio. It is called a multifactor model with more factors. Primarily, Ross (1976a, 1976b) developed The Arbitrage Pricing Theory (APT). It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. Ross argues that if equilibrium prices offer no arbitrage opportunities over static portfolios of the assets, then the expected returns on the assets are approximately linearly related to the factor loadings. (The factor loadings, or betas, are proportional to the returns’ co-variance with the factors.)

According to Azhar Bin Zakaria (2006), the equilibrium-pricing model using Arbitrage Pricing Theory (APT) has developed into one of the modern financial theory. However, the use of APT in determining the factors which influences expected returns is too general. APT often viewed as a substitute to the capital asset pricing model (CAPM). Market’s expected return is used in the CAPM formula, while APT uses risky asset’s expected return and the risk premium. APT model are used by arbitrageurs to profit by taking benefit of mispriced securities (Azhar Bin Zakaria, 2006). A mispriced security will have a price which is different from the model prediction hypothetical price. By going short an overpriced security, while in going long the portfolio the APT calculations were based on the arbitrageur to make a risk-free turnover.

BACKGROUND RESEARCH

THE ARBITRAGE PRICING THEORY (APT) MODEL

The return on a stock can be calculated by the following APT formula stated by Ross (1976):

Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)… + bn x (factor n)

Where:

rf = The risk free interest rate (interest rate the investor would expect to receive from a risk free investment)

b = the sensitivity of the stock to each factor

factor = the risk premium associated with each factor

The following two factors influence the risk premium in the APT model:-

The risk premiums associated with each of the factors described above

The sensitivity of stock to each of the factors – similar to the beta concept

Risk Premium = r -rf = b(1) x (r factor(1) – rf) + b(2) x (r factor(2) – rf)… + b(n) x (r factor(n) – rf)

Ross (1976) added the patron would sell the stock if the expected risk premium on a stock were lesser. The patron would buy the stock if the risk premium were higher, until both sides of the equation were in balance. Investors could go about getting this formula back into equilibrium is by using the arbitrage term.

ARBITRAGE PRICING THEORY ASSUMPTIONS

According to Dr. Rodney Boehme (n.d) there are 2 assumptions for the model. Firstly, only the systematic risk is relevant in determining expected returns (similar to CAPM). However, there may be several non-diversifiable risk factors (different from CAPM, since CAPM assumes only one risk factor) that are systematic or macroeconomic in nature and thus affect the returns of all stocks to some degree. Secondly, firm specific risk, since it is easily diversified out of any well-diversified portfolio, is not relevant in determining the expected returns of securities (similar to CAPM).

FACTORS USED IN ARBITRAGE PRICING THEORY

There is no formal theoretical guidance in choosing the appropriate group of economic factors to be included in the APT model (Azeez & Yonoezawa, 2003; Mauri Paavola, 2006).

Paavola (2006) explains further that this is both its strength and its weakness. It is strength in empirical work since it permits the researcher to select whatever factors provide the best explanation for the particular sample at hand; it is weakness in practical applications because, in contrast to the CAPM, it cannot explain variation in asset returns in terms of limited and easily identifiable factors, such as equity’s beta. (Groenewold & Fraser, 1997; Mauri Paavola, 2006)

Berry et al. (1988) ; Mauri Paavola, 2006 gave good and simple instructions of what kind of variables qualify as legitimate risk factors in the APT framework. They state that legitimate risk factors must possess three important properties:

At the beginning of every period, the factor must be completely unpredictable to the market.

Each APT factor must have a pervasive influence on stock returns.

Relevant factors must influence expected return; i.e. they must have non-zero pri