This is one of which the two prevailing theories that try to explain valuation of assets. The other is Capital Asset Pricing Model which can be considered the special case of APT. In this theory it is believed that the factors that have an effect on the value of particular asset form the equation that gives the expected return of this asset. The formula is expressed as follows:
r = rf + β1f1 + β2f2 + β3f3 + ...
- r expected return
- rf risk free rate
- f factor
- β measure of the relationship between the security price and that factor.
The model is based on the idea that if any divergence occurs at the price of a particular asset, the arbitrage process brings its value back into line.
The difference between CAPM and arbitrage pricing theory is that CAPM has a single non-company factor and a single beta, whereas arbitrage pricing theory divides them into different factors. Each factor has a separate beta. The beta of each factor is the sensitivity of the price of the security to that factor.
APT directly relates the price of the security to the fundamental factors driving it. APT does not suggests what type of factors drive the valuation of that security. Therefore these factors need to be worked out empirically. The most obvious factors are economic growth and interest rates. For companies in some sectors other factors are obviously relevant as well - such as consumer spending for retailers.
The value of Betas are calculated through linear regression analysis of historical security returns on the factor in question. The number and the nature of these factors, hence betas, are likely to change over time along with economic conditions.
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