Derivatives Models on Models

Stephen Ross on APT

Stephen A. Ross is best known as the inventor of the Arbitrage Pricing Theory, as well as the co-discoverer of the binomial model for pricing derivatives. His book, “Corporate Finance”, is in its seventh edition. Stephen Ross is Professor in Financial Economics at MIT Sloan School of Management.

Haug : Where did you grow up?

Ross : Brookline, Massachusetts, USA.

Haug : What is your educational background?

Ross : BA in physics from CalTech and Ph.D. in economics from Harvard.

Haug : How and when did the idea of risk-neutral valuation first come into being, and what was your contribution to it?

Ross : I first discovered the equivalence between no arbitrage and the existence of a positive linear pricing. Independently John Cox and I discovered risk neutral pricing in the context of option pricing theory. We subsequently realized that it was a representation of the fundamental equivalence I had discovered earlier.

Haug : In your own words, what is Arbitrage Pricing Theory (APT)?

Ross : It is a simple theory that builds on the most successful idea in modern finance if not in all of economics, namely that there can be no arbitrage possibilities simply available. In the case of the APT it has two components. First, the assumption is made that returns are generated by a linear factor model, i.e., there are a limited number of factors that affect all asset returns and their affects add to the total systematic impact for each asset. Second, the idiosyncratic effects on ...