ARBITRAGE PRICING
THEORY
What is Arbitrage?
It refers to the simultaneous buying and
selling of securities, currency, or
commodities in different markets or in
derivative forms in order to take advantage
of differing prices for the same asset.
It is the purchase of securities on one
market for immediate resale on another
market in order to profit from a price
discrepancy. This results in immediate risk-
free profit.
Traders who engage in arbitrage are known
as "arbitrageurs".
Arbitrage Pricing Theory (APT)
Stephen A. Ross is a Professor of
Finance at the MIT Sloan School of
Management.
Ross is the author of more than 100
articles in economics and finance and
is the co-author of an introductory
textbook in finance. He is probably
best known for having invented the
Arbitrage Pricing Theory which he
created in 1976.
Current Research
Focus: Ross’s research
is currently focused on
extending and applying
the Recovery Theorem.
The Recovery Theorem
enables us to extract or
“recover,” from the
prices of options, the
market’s probability
distribution for future
returns.
Arbitrage in Trading
Arbitrage is the simultaneous
purchase and sale of an asset to profit
from a difference in the price. It is a
trade that profits by exploiting the
price differences of identical or similar
financial instruments on different
markets or in different forms.
Arbitrage exists as a result of market
inefficiencies.
PURE ARBITRAGE
Issaid to be risk-free.
Market inefficiencies can mean
that the price of an asset
occasionally differs between
markets. For example, it might be
possible to buy an asset for a low
price in one market, and then
immediately sell it for a slightly
higher price in another market.
Example
Let'ssay you are able to buy a toy doll
for $15 in Tallahassee, Florida, but in
Seattle, Washington, the doll is selling
for $25. If you are able to buy the doll
in Florida and sell it in the Seattle
market, you can profit from the
difference without any risk because
the higher price of the doll in Seattle
is guaranteed.
This type of arbitrage requires the violation of at
least one of these three conditions:
1. The same security must trade at the
same price on all markets.
2. Two securities with identical
cash flows must trade at the same
price.
3. A security with a known price in the
future (via a futures contract) must
trade today at that price discounted
by the risk-free rate.
RISK ARBITRAGE
Another type of arbitrage is
"risk" arbitrage which
involves a more speculative
approach.
THREE TYPES
Merger and Acquisition
Liquidation
Pairs Trading
Example: ACQUISITION
Let's say Company A is currently trading at
$10/share. Company B, which wants to acquire
Company A, decides to place a takeover bid on
Company A for $15/share. This means that all of
Company A's shares are now worth $15/share, but
are trading at only $10/share. Let's say the early
trades (typically not retail trades) bid it up to
$14/share. Now, there is still a $1/share
difference--an opportunity for risk arbitrage. So,
where's the risk? Well, the acquisition could fall
through, in which case the shares would be worth
only the original $10/share.
Example 2
If it becomes known that the shares of
Company A will soon be priced at $15
(after a takeover for example), but
those shares are currently trading at
$10, a trader could engage in
arbitrage by purchasing shares at the
lower price and selling them later
(once they have reached the expected
higher price), in order to make a
profit.
TRIANGULAR ARBITRAGE
A trader converts one currency to
another at one bank, converts that
second currency to another at a
second bank, and finally converts the
second currency back to the original
at a third bank. The same bank would
have the information efficiency to
ensure all of its currency rates were
aligned, requiring the use of different
financial institutions for this strategy.
For example, assume you begin with $2
million. You see that at three different
institutions the following currency
exchange rates are immediately
available:
Institution 1: Euros/USD = 0.894
Institution 2: Euros/British pound =
1.276
Institution 3: USD/British pound = 1.432
First,
you would convert the $2 million
to euros at the 0.894 rate, giving you
1,788,000 euros. Next, you would
take the 1,788,000 euros and convert
them to pounds at the 1.276 rate,
giving you 1,401,254 pounds. Next,
you would take the pounds and
convert them back to U.S. dollars at
the 1.432 rate, giving you
$2,006,596. Your total risk-free
arbitrage profit would be $6,596.
Are there any risks involved in
arbitrage?
Technically, "pure" arbitrage is said to be
risk free, although this is often not the case
in practice. There is a chance that part of
the transaction could fail, and a sudden
price movement may make it impossible to
close the trade at a profit.
"Risk" arbitrage involves a greater amount
of risk as there is always a possibility that
the price of an asset may not move as
anticipated.
Arbitrage provides a mechanism to ensure
prices do not deviate substantially from
fair value for long periods of time. With
advancements in technology, it has become
extremely difficult to profit from pricing
errors in the market. Many traders have
computerized trading systems set to
monitor fluctuations in similar
financial instruments. Any inefficient pricing
setups are usually acted upon quickly, and
the opportunity is often eliminated in a
matter of seconds. Arbitrage is a necessary
force in the financial marketplace.
HOW IT WORKS:
The APT formula is:
E(r ) = r + b RP + b RP + b RP + b RP +
j f j1 1 j2 2 j3 3 j4 4
... + bjnRPn
where:
E(rj) = the asset's expected rate of return
rf = the risk-free rate
bj = the sensitivity of the asset's return to
the particular factor
RP = the risk premium associated with the
particular factor
Why it Matters:
The APT was a revolutionary model because
it allows the user to adapt the model to the
security being analyzed. And as with other
pricing models, it helps the user decide
whether a security is undervalued or
overvalued and so he or she can profit from
this information. APT is also very useful for
building portfolios because it allows
managers to test whether their portfolios
are exposed to certain factors.
APT may be more customizable than CAPM,
but it is also more difficult to apply because
determining which factors influence a stock
or portfolio takes a considerable amount of
research. It can be virtually impossible to
detect every influential factor much less
determine how sensitive the security is to a
particular factor. But getting "close enough"
is often good enough; in fact studies find
that four or five factors will usually explain
most of a security's return: surprises in
inflation, GNP, investor confidence and
shifts in the yield curve.