(99)---THE ARBITRAGE PRICING THEORY

The Arbitrage Pricing Theory

The capital asset pricing model is not always able to account for the difference is assets, returns using their betas. This paved way for the development of an alternative approach, called the arbitrage pricing theory, for estimating the assets “expected returns”.

Arbitrage pricing theory unlike capital asset pricing model, does not assume that investors employ mean variance analysis for their investment decisions. However, like capital asset pricing model, arbitrage pricing theory is found on the notion that investors are rewarded for assuming non diversifiable risk, diversifiable risk is not compensated beta is considered as the most important single factor in capital asset pricing model that captures the systematic risk of an asset.

In arbitrage pricing theory there are a number of industry specific and macro economic factors that affect the security returns. Thus a number of factors may measure the systematic risk of an asset under arbitrage pricing theory.

The fundamental logic of arbitrage pricing theory is that investors always indulge in arbitrage whenever they find differences in the returns of assets with similar risk characteristics.