Arbitrage Pricing Theory

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This paper is an analysis of the Arbitrage Pricing Theory (APT) of Ross (1976). The paper includes the determination of the problems that exist during the selection of the factors in asset pricing. Arbitrage Pricing Theory was developed by Ross in 1976, the start of a great change in the market industry.


To be able to show the problems, I make use of the study done by Lehman and Modest (1985), which come up into three conclusions. The analysis of Lehman and Modest was able to show that one of the problems in determining the factor for asset pricing is the proper or the correct use of procedure. Lehman and Modest opposed Fama-Macbeth in using the maximum likelihood analysis in determining the factors. Another study included in this paper is the one done by Enrico Altay (2003) using the Germany and Turkish stock exchange. In his study he uses the Fama-Macbeth maximum likelihood analysis. This causes the difference in the result.
Therefore, in analysing the stock exchange one should be aware of the models and theory being used. The arbitrage pricing theory may encounter several problems especially in analyzing the factors. The macroeconomic factors may affect the outcome in pricing the asset. The analysis in which the best portfolio perform best remains. The arguments are presented in the later part of the paper.
Arbitrage Pricing Theory (APT), is a general theory of asset pricing. It holds the expected return of a financial asset that can be modelled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor specific beta coefficient. This theory was initiated by the economist Stephen Ross in 1976.
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