An Empirical Investigation of the Arbitrage Pricing Theory, Journal of Finance, by Roll, R. And Ross, S. A. (1980),
The
study focuses on the arbitrage pricing theory of asset. The arbitrage pricing
theory (APT) formulated by Ross offers
a testable alternative to the well-known capital asset pricing model (CAPM)
introduced by Sharpe,Lintner and Mossin. Although the CAPM has been
predominant in empirical work over the
past fifteen years and is the basis of modern portfolio theory.
To the contrary, elegant derivations of the CAPM equation have been concocted beginning from the first principles of utility theory; but the model's popularity is not due to such analyses, for they make all too obvious the assumptions required for the CAPM's validity and make no use of the common variability of returns. The APT is a particularly appropriate alternative because it agrees perfectly with what appears to be the intuition behind the CAPM. Indeed, the APT is based on a linear return generating process as a first principle, and requires no utility assumptions beyond monotonicity and concavity. Nor is it restricted to a single period; it will hold in both the multi-period and single period cases. There are two major differences between the APT and the original Sharpe "diagonal" model, a single factor generating model which they believe is the intuitive grey eminence behind the CAPM. First, and most simply, the APT allows more than just one generating factor. Second, the APT demonstrates that since any market equilibrium must be consistent with no arbitrage profits, every equilibrium will be characterized by a linear relationship between each asset's expected return and its return's response amplitudes, or loadings, on the common factors. With minor caveats, given the factor generating model, the absence of riskless arbitrage profits-an easy enough condition to accept a priori-leads immediately to the APT. Its modest assumptions and its pleasing implications surely render the APT worthy of being the object of empirical testing. The objective of the research is to use the APT framework to investigate both the existence and the pricing questions. Which includes to determine, that a more complete discussion of the unique testable features of the APT is provided. Then section II gives our basic tests. It concludes that three factors are definitely present in the "prices" (actually in the expected returns) of equities traded on the New York and American Exchanges. However the fourth factor may be present also but the evidence there is less conclusive.
To the contrary, elegant derivations of the CAPM equation have been concocted beginning from the first principles of utility theory; but the model's popularity is not due to such analyses, for they make all too obvious the assumptions required for the CAPM's validity and make no use of the common variability of returns. The APT is a particularly appropriate alternative because it agrees perfectly with what appears to be the intuition behind the CAPM. Indeed, the APT is based on a linear return generating process as a first principle, and requires no utility assumptions beyond monotonicity and concavity. Nor is it restricted to a single period; it will hold in both the multi-period and single period cases. There are two major differences between the APT and the original Sharpe "diagonal" model, a single factor generating model which they believe is the intuitive grey eminence behind the CAPM. First, and most simply, the APT allows more than just one generating factor. Second, the APT demonstrates that since any market equilibrium must be consistent with no arbitrage profits, every equilibrium will be characterized by a linear relationship between each asset's expected return and its return's response amplitudes, or loadings, on the common factors. With minor caveats, given the factor generating model, the absence of riskless arbitrage profits-an easy enough condition to accept a priori-leads immediately to the APT. Its modest assumptions and its pleasing implications surely render the APT worthy of being the object of empirical testing. The objective of the research is to use the APT framework to investigate both the existence and the pricing questions. Which includes to determine, that a more complete discussion of the unique testable features of the APT is provided. Then section II gives our basic tests. It concludes that three factors are definitely present in the "prices" (actually in the expected returns) of equities traded on the New York and American Exchanges. However the fourth factor may be present also but the evidence there is less conclusive.
For more details on the methodology adopted for the research and the conclusion, leave your comment or twit @anacom_okey
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