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ARBITRAGE PRICING THEORY

The arbitrage pricing theory helps in finding a relationship between the return and the various macro economic factors. This theory was developed by Stephen Ross. It is also an alternate way of price calculation for an asset. The basic difference between the two theories is that in capital asset pricing method the relationship between the risk and return is found whereas in the arbitrage pricing method the relationship between the return and the major economic factors are determined. Arbitrage pricing theory is always termed as an alternate way to determine the return and the price of the portfolio. Capital asset pricing uses market expected return, whereas arbitrage pricing theory uses risky asset's expected return and the risk premium of a number of macro-economic factors.

The similarity between the two model is that both the model are used to determine the price and hence is called pricing model. Both are highly used pricing models. The person who uses arbitrage pricing theory for calculation is called arbitrageur. Arbitrageurs find out whether the portfolio is over priced or under priced. Arbitrageurs go short on the portfolio which is over priced and goes long on the portfolio which is under priced.

The arbitrage pricing theory is widely used in stock market to identify the equity price position.

The formula used in arbitrage pricing is,

r = rf1f12f23f3+....

Where expected return is denoted as r, risk free return is denoted as rf, separate factor is denoted by f and the relationship between the security price and other environmental factor is given by β.

The arbitrage pricing model is used in the place where there is a huge influence of the external environmental factors like inflation, interest rate, economic growth etc. The major difference between the two models is that in this model there is fluctuation in β the value changes since the external factor is not constant and it will be fluctuating.

The investor decides upon which model to use based on the situation. If the investor feels that the environment does not play major role in the investment portfolio they will go for capital asset pricing, whereas when they feel that environmental factors have influence in the portfolio they will go for Arbitrage pricing model.

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