Modern Portfolio Theory: Foundations, Analysis, and New Developments, + Website

Chapter 16

Arbitrage Pricing Theory

Although the principal topic of this book is portfolio analysis and the CAPM, it should be kept in mind that academic acceptance of the CAPM as the premier asset pricing paradigm is less than universal. The arbitrage pricing theory (APT), formulated by Ross (1976, 1977b), is considered as an alternative pricing model like Breeden's consumption-based CAPM and Merton's intertemporal CAPM. APT is less restrictive than the CAPM in that it applies in both the single-period and multiperiod settings. Furthermore, it is based on fewer and more realistic assumptions. APT only requires us to assume that markets are perfectly competitive and investors' utility functions are monotonically increasing and concave.¹ The CAPM assumptions of quadratic utility functions and/or normally distributed returns are not necessary in deriving the asset pricing equation of APT.

16.1 Arbitrage Concepts

Arbitrage is a trading strategy that exploits the mispricing of two or more assets. If the prices of some securities are not properly aligned, for instance, it is possible to earn risk-free profits by simultaneously trading the mispriced assets. Two or more securities that are economically equivalent should have the same expected return. If the expected returns are not equal, the economic law of one price states that profitable arbitrage is possible. To generate a risk-free profit from misaligned prices, arbitrageurs purchase a long position in the cheaper security that is ...