Saturday, December 5, 2009


Concept of Return under Arbitrage Pricing Theory

In Arbitrage Pricing Theory, the return of an asset is assumed to have two components, predictable and unpredictable return.

The predictable or expected return depends on the information available to shareholders that a bearing on the share prices. The unpredictable or uncertain return arises from the future information. This information may be the firm specific and the market related macro economic factors.

The firm specific factors are special to the firm and affected only the firm. The market related factors affect all firms. Thus the uncertain return may come from the firm specific information and the market related information.

It is important to notice that the economy wide information may be future divided into the expected part and the unexpected or surprise part.

For example, the government may announce that inflation rate would be 5% next month. Since this information is already known, market would have already accounted for this and share prices would reflect it. After a month the government announces that the actual inflation rate was 6%. Share holders known now that the inflation is 1% higher than the anticipated rate. This is surprise news to them. The expected part of information influences the expected return while the surprise part affects the unexpected part or return.