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BBC Reporter Clare Forestier

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Arbitrage Pricing Theory Model Formula 

E(R)i​=E(R)z​+(E(I)−E(R)z​)×βn

where:

E(R)i​=Expected return on the asset

Rz​=Risk-free rate of return

βn=Sensitivity of the asset price to macroeconomicfactor n

Ei=Risk premium associated with factor i​

Arbitrage Pricing Theory (APT)

Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from a Value Investing perspective, in order to identify securities that may be temporarily mispriced.

KEY TAKEAWAYS

👉 Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk.

👉 Unlike the CAPM, which assumes markets are perfectly efficient, APT assumes markets sometimes mispriced securities, before the market eventually corrects and securities move back to fair value.

👉 Using APT, arbitrageurs hope to take advantage of any deviations from fair market value.

Formula for the Arbitrage Pricing Theory Model 

E(R)i​=E(R)z​+(E(I)−E(R)z​)×βn

where:

E(R)i​=Expected return on the asset

Rz​=Risk-free rate of return

βn=Sensitivity of the asset price to macroeconomicfactor n

Ei=Risk premium associated with factor i​

Mathematical Model for the APT

While APT is more flexible than the CAPM, it is more complex. The CAPM only takes into account one factor—market risk—while the APT formula has multiple factors. And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks.

The factors as well as how many of them are used are subjective choices, which means investors will have varying results depending on their choice. However, four or five factors will usually explain most of a security's return. (For more on the differences between the CAPM and APT, read more about how CAPM and arbitrage pricing theory differ.)

APT factors are the systematic risk that cannot be reduced by the diversification of an investment portfolio. The macroeconomic factors that have proven most reliable as price predictors include unexpected changes in inflation, Gross National Product (GNP), corporate bond spreads and shifts in the yield curve. 

Other commonly used factors are Gross Domestic Product (GDP), commodities prices, market indices, and exchange rates.

Cooperative

In modern times, a mutual company is a Legal Entity that is owned by its customers or policyholders. The company's customers are also its owners. As such, they are entitled to receive a share of the profits generated by the mutual company.

The distribution of profits is typically made in the form of dividends paid on a pro rata basis, based on the amount of business each customer conducts with the mutual company. Alternately, some mutual companies choose to use their profits to reduce members' premiums.

The Legal Entity is also referred to as a Cooperative.

Monetary System

Monetary System components include a set of Policies, Regulatory Frameworks, and Institutions by which a Government Creates Money in an economy. Such institutions include the Mint, the Central Bank, Treasury, and other Financial Institutions. 

There are Three Common Types of Monetary Systems;

1. Commodity Money 

2. Commodity-based Money 

3. Fiat Money

Comparative Case Studies

👉 IMF Monetary Policy in the Presence of Islamic Banking

👉 Monetary Policy and Central Banks

👉 OECD Economic Policy Reforms

👉 Organization of Islamic Cooperation (OIC) RESOLUTIONS ON ECONOMIC AFFAIRS

👉 United Nations ECONOMIC AND SOCIAL CHALLENGES AND OPPORTUNITIES 

👉 USA Federal Reserve System Monetary Policy Principles and Practice

👉 World Bank Group Policy Challenges for Emerging and Developing Economies