Arbitrage pricing theory helps set the pricing model for stocks by representing the anticipated return on any asset as a linear calculation of macroeconomic factors and market indices. It is commonly used in today’s stock market to analyze current conditions and respond accordingly.
One of the first things to understand about arbitrage pricing theory is that the concept has to do with the process of pricing assets. Essentially, arbitrage pricing theory, or APT for short, helps set the pricing model for various stocks. Here is some information about arbitrage pricing theory and why this concept is so useful in determining the pricing model for buying and selling stocks.
Developed by economist Stephen Ross in 1976, the underlying principle of price theory involves the recognition that the anticipated return on any asset can be represented as a linear calculation of relevant macroeconomic factors together with market indices. There is expected to be a rate of change in most, if not all, relevant factors. Running scenarios with this model helps arrive at a price that is fair to the anticipated return of the asset. The desired result is that the asset price will equal the anticipated price by the end of the quoted period, with the final price discounted at the rate implicit in the Capital Asset Pricing Model. It is understood that if the price of the asset deviates from the course, that arbitrage will help the price to return to reasonable perimeters.
In practical application, using arbitrage pricing theory can work very well when trying to increase the long-term value of a stock portfolio. For example, using APT when the current price is very low would result in a simple process that would generate a return while keeping the wallet safe. The first step would be to short the portfolio, then buy the low-priced asset with the proceeds. At the end of the period, the low-priced asset, which will have increased in value, will be sold and the proceeds will be used to buy back the recently sold portfolio. This strategy generally results in a modest amount of income for the investor.
A similar strategy is employed when the current price is high. With this set of circumstances, the investor would short the high-priced asset and use the proceeds to purchase the portfolio. At the end of the period, the investor would then sell the portfolio, use a portion of the proceeds to buy back the high-priced asset, and once again cash in on the transaction.
The use of arbitrage pricing theory is very common in today’s stock market. In some ways, the theory’s use is even more widespread than ever, with more investors having access to real-time information through online methods than at any previous point in trading history. As a means of analyzing current conditions and responding accordingly, arbitrage pricing theory has a strong track record, and will no doubt be used by investors and analysts for many years to come.
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