Arbitrage Pricing Model Research Articles

Asset Pricing Theory and the Predictable Variation in Agricultural Asset Returns

AbstractThis study focuses on the time‐series predictability of agricultural returns and evaluates the ability of conditional asset pricing models to capture such predictability. The models all have time‐varying conditional risk premia and constant betas, as opposed to the unconditional specifications in prior studies. Results indicate significant time‐varying predictability in agricultural asset returns. An Arbitrage Pricing model with prespecified economic factors, including a market portfolio, shows some ability to explain the predictability. The greater flexibility and information in conditional asset pricing models make them more suitable than unconditional models for many problems in agricultural finance.

Expected returns and volatility in European stock markets

The type of return generating process we test here on three European markets are GARCH and AR GARCH in mean models with innovations that have either normal or student-t densities with time dependant variances. These models are appealing in that they estimate time varying volatility in disturbances of stock returns series and ex -ante relationship between stock returns and volatility. Our results indicate that there is no statistically significant coefficient estimates for the volatility in the mean equation and that variance might not be appropriate as a measure of Other proxies for risk should then be searched for. I. Introduction A considerable number of studies in financial economics, both empirical and theoretical, relate expected returns on common stocks to the notion of These studies mainly measure a stock's risk as the covariance between its return and one or more variables. For instance, the capital asset pricing model of Sharpe (1964) relates returns of stocks to their covariances with the market portfolio's returns; the arbitrage pricing model of Ross (1976) relates stock returns to their covariances with several factors; and the consumption asset pricing model of Breeden (1979) relates stock returns to their covariances with the aggregate consumption. These models have been thoroughly tested, but, in recent years, the increasing evidence of time variation in expected returns an d risk put into question the implications and relevance of these models. Many researchers have in turn re -examined financial valuation models in the conditional form that allow expected returns to vary over time (see Gibbons and Ferson (1985), Keim and Stambaugh (1986), and Campbell (1987)), or both expected returns and variance to be time varying (see French, Schwert, and Stambaugh (1987), Baillie and De Gennaro (1990)). One point emerging from these studies, though not strongly conclusive, is that the use of variance to model risk might not be appropriate. Baillie and De Gennaro, for instance, conclude that their results show almost no evidence of a relationship between mean returns on a portfolio of stocks and the variance or standard deviation of those returns. This implies that simple mean -variance models are inappropriate, and suggests the importance of further research using alternative measures of risk. The notion of variance as a sole proxy for risk has already been questioned in the literature. Am ong others, Kraus and Litzenberger (1976) developed a three moment model in which the investors are averse to variance but prefer positive skewness, and Price, Price, and Nantell (1982) and Bawa and Lindenberg (1977) used lower partial moments in their models. Insofar these studies, which have been exclusively applied to the American markets, have not produced conclusive results. Whether the notion of variance is a good measure of risk in European stock markets is the concern of this paper. The type of return generative processes we test here are GARCH and AR-GARCH in mean models with innovations that have either normal or student -t densities with time dependant variances. These models are appealing in the sense that they estimate time varying volatility in disturbances of stock returns series and ex-ante relationship between stock returns and volatility. The structure of the paper is the following. Sections two and three present the data and the statistical analysis. In the fourth section autoregressive cond itional heteroskedastic processes are discussed. The next section is then devoted to empirical results and their interpretations.

On the existence of common factors in the arbitrage pricing model: international evidence from US and Scandinavian stock markets

The purpose of this paper is to test the arbitrage pricing model (APM) using monthly data for US, Finnish and Swedish stock returns during the 1977–86 period. First, the intra-country stability of the factor patterns of the APM is researched in two exclusive subperiods. Second, the cross-sectional similarities of the factor patterns of twelve 30-stock samples collected from the three countries are investigated. Empirical evidence indicates the existence of two common factors. In addition, it is found that these factors are often produced in different order in different samples. Studying the association between the estimated factors and equilibrium returns indicates that for US and Swedish stocks one or two factors are priced, and for Finnish stocks only one factor is priced in the first subperiod.

Terms of Trade Shifts and International Macroeconomic Fundamentals

This paper focuses on the relationship between developing-country terms of trade and underlying economic fundamentals in the industrial economies. The focus is limited to the terms of trade of the five developing-country regions (Africa, Asia, Europe, the Middle East, and the Western Hemisphere). The analysis is based on a version of the arbitrage pricing model, which is used extensively in the literature on capital market analysis. This model links developing-country terms of trade to indicators of international macroeconomic fundamentals. In this model the terms of trade are characterized as the price of a hedge portfolio consisting of a long position in exports and a short position in imports. The primary finding is that there does not appear to be an important link between developing-country terms of trade and underlying fundamentals in the industrial countries.

The federal funds rate and the arbitrage pricing theory: Evidence that monetary policy matters

Macroeconomists disagree concerning whether monetary policy affects real variables. Recently, Bernanke and Blinder have presented evidence that the federal funds rate is a good indicator of monetary policy and that it forecasts real variables well. Here we use a nonlinear seemingly unrelated regression technique to demonstrate that the funds rate is a priced factor in the arbitrage pricing model and that unexpected increases (decreases) in the funds rate lower (raise) stock prices. This provides evidence from a different data set using a different methodology corroborating Bernanke and Blinder's finding that monetary policy working through the funds rate affects real activity.

Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation

This paper presents a unifying theory for valuing contingent claims under a stochastic term of interest rates. The methodology, based on the equivalent martingale measure technique, takes as given an initial forward rate curve and a family of potential stochastic processeE for its subsequent movements. A no arbitrage condition restricts this family of processes yielding valuation formulae for interest rate sensitive contingent claims which do not explicitly depend on the market prices of risk. Examples are provided to illustrate the key results. IN RELATION TO the term of interest rates, arbitrage pricing theory has two purposes. The first, is to price all zero coupon (default free) bonds of varying maturities from a finite number of economic fundamentals, called state variables. The second, is to price all interest rate sensitive contingent claims, taking as given the prices of the zero coupon bonds. This paper presents a general theory and a unifying framework for understanding arbitrage pricing theory in this context, of which all existing arbitrage pricing models are special cases (in particular, Vasicek (1977), Brennan and Schwartz (1979), Langetieg (1980), Ball and Torous (1983), Ho and Lee (1986), Schaefer and Schwartz (1987), and Artzner and Delbaen (1988)). The primary contribution of this paper, however, is a new methodology for solving the second problem, i.e., the pricing of interest rate sensitive contingent claims given the prices of all zero coupon bonds. The methodology is new because (i) it imposes its stochastic directly on the evolution of the forward rate curve, (ii) it does not require an inversion of the term structure to eliminate the market prices of risk from contingent claim values, and (iii) it has a stochastic spot rate process with multiple stochastic factors influencing the term structure. The model can be used to consistently price (and hedge) all contingent claims (American or European) on the term structure, and it is derived from necessary and (more importantly) sufficient conditions for the absence of arbitrage. The arbitrage pricing models of Vasicek (1977), Brennan and Schwartz (1979), Langetieg (1980), and Artzner and Delbaen (1988) all require an IFormerly titled Bond Pricing and the Term Structure of Interest Rates: A New Methodology.

The Pricing of Exchange Rate Risk in the Stock Market

This paper examines the pricing of exchange rate risk in the U.S. stock market, using two factor and multi-factor arbitrage pricing models. Evidence is presented that the relation between stock returns and the value of the dollar differs systematically across industries. The empirical results, however, do not suggest that exchange risk is priced in the stock market. The unconditional risk premium attached to foreign currency exposure appears to be small and never significant. As a result, active hedging policies by financial managers cannot affect the cost of capital, and other reasons must explain why firms decide to hedge.

On the riskiness of the world's stock markets

The main aim of this paper is to study the riskiness of the world's stock markets. This is carried out by applying the concepts of the two main asset pricing models: the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Model (APM). Certain obvious risk categories among world stock markets exist. Three major potential reasons for the existence of these different risk categories are reported. Firstly, economic trade and currency areas seem to affect the riskiness of different stock markets, with North American, European and Oceanic stock exchanges quite clearly creating their own separate factors. Secondly, the level of institutional development of a given market also appears to be a factor determining its riskiness. Thin stock markets, such as those of Finland and Mexico seem to exhibit a different price behaviour of their own. Thirdly, the combined effect of different time zones and efficiency is discussed, especially in the case of the UK stock markets vs. other European stock markets.

Risk and Return on Real Estate: Evidence from Equity REITs

We analyze monthly returns on an equally weighted index of eighteen to twenty‐three equity (real property) real estate investment trusts (REITs) that were traded on major stock exchanges over the 1973–87 period. We employ a multifactor Arbitrage Pricing Model using prespecified macroeconomic factors. We also test whether equity REIT returns are related to changes in the discount on closed‐end stock funds, which seems plausible given the closed‐end nature of REITs.Three factors, and the percentage change in the discount on closed‐end stock funds, consistently drive equity REIT returns: unexpected inflation and changes in the risk and term structures of interest rates. The impacts of these variables on equity REIT returns is around 60% of the impacts on corporate stock returns generally. As expected, the impacts are greater for more heavily levered REITs than for less levered REITs. Real estate, at least as measured by the return performance of equity REITs, is less risky than stocks generally, but does not offer a superior risk‐adjusted return and is not a hedge against unexpected inflation.

Common factors in the arbitrage pricing model in two Scandinavian countries

The purpose of this paper is to test the Arbitrage Pricing Theory (APT) using monthly data for Finnish and Swedish stock returns during the 1977–1986 period. The first stage involves estimating the systematic risk components for each asset using factor analysis. The second stage involves testing if the number and structure of factors which influence the security returns remain unchanged across various time periods and across different samples in the two Scandinavian countries. For this purpose, a new method called transformation analysis is introduced. Empirical evidence indicates that two or three common factors in these two neighbouring countries can be found.

AN INTERNATIONAL ARBITRAGE PRICING MODEL WITH PPP DEVIATIONS

This paper derives an intertemporal, international arbitrage pricing model that relaxes more assumptions than previous asset pricing paradigms. The analysis shows how risk, risk premia, and the translation of these variables between all real and nominal numeraires depend upon a small number of stochastic state variables that define the economy's production and credit opportunities. When the model is applied to the forward exchange market, it highlights the potentially central role of real exchange rates in determining the evolution of forward exchange risk premia.

Model selection for measuring security price performance

In this article a bootstrapping routine is used to compare the efficiency of different benchmarks that can be used for measuring security price performance on the Johannesburg Stock Exchange. Four approaches are compared; three benchmarks based on the theory of the Capital Asset Pricing Model, and one, a two-factor benchmark, based on the theory of the Arbitrage Pricing Model. The findings show that, for the JSE, the two-factor approach is superior. This is consistent with prior research into the South African securities market where evidence of two clear factors influencing security returns have been found. The recommendation is that the two-factor benchmark be used for measuring security price performance on the JSE, especially for small samples where only limited benefits can be expected through the central limit theorem.

A Test of the Cross‐Sectional Robustness of the Arbitrage Pricing Model Using Foreign Exchange Rates*

ABSTRACTThis paper tests the cross‐sectional robustness of the arbitrage pricing theory (APT) model using foreign exchange rate data to determine if the model is robust with respect to the various random samples and various factor analytic techniques. Factor scores are developed using various samples and factor analytic techniques to explain the returns for other samples and groupings. The APT model is found to be robust across samples and techniques.

Arbitrage Pricing Models for two Scandinavian stock markets

This paper examines the Arbitrage Pricing Models (APM) for Finnish and Swedish data. The testing is based on weekly returns of portfolio-aggregated data, partly to achieve multivariate normality, partly to dampen outlier effects. Data of beta-ranked portfolios used elsewhere in testing the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are used here too and provides a convenient basis for dominance testing of CAPM and APT. Following Chen, the dominance relationship is analyzed by the Davidson-Mackinnon test and the Posterior Odds Ratio test. The tests indicate that APT dominates CAPM in both countries. The Finnish loadings turned out to be more volatile than the Swedish. Furthermore, the multiple factor model is seen to have relatively more power in Finnish than in Swedish conditions. The results are consistent with previous evidence, that the single factor model (CAPM) tends to be more powerful in explaining Swedish than Finnish stock returns. Since the testing is based on portfolio-aggregated weekly returns series, the results do not necessarily agree with those for daily returns at the individual asset level.

Managing Acquisitions of Strategic Business Units with the Aid of the Arbitrage Pricing Model

The Arbitrage Pricing Model (APM), developed in the securities investment literature, can enhance corporate managers' insights into the economic sensitivities of potential acquisition candidates. It may provide managers with greater analytical power than such popular models as the G. E. Business Screen and the Boston Consulting Group model. Use of the APM should improve the effectiveness of the acquisition screening process.

Managing Acquisitions of Strategic Business Units with the Aid of the Arbitrage Pricing Model

Managing Acquisitions of Strategic Business Units with the Aid of the Arbitrage Pricing Model

ARBITRAGE PRICING MODELS: THE SUFFICIENT NUMBER OF FACTORS AND EQUILIBRIUM CONDITIONS

AbstractThe typical methodology for estimating an Arbitrage Pricing Model is inadequate with respect to two issues. First, the statistical tests used to determine the sufficient number of factors are inappropriate and may actually overstate the relevant number of factors. Second, the methodology fails to determine whether the estimated model satisfies equilibrium conditions. A simple test that corrects both deficiencies is developed in this paper.

Recent Developments in the pricing of financial assets

The Capital Asset Pricing Model (CAPM) has been extensively used by academics and practitioners during the last twenty years. Particularly in the last decade the validity of tests of the model and the model itself have been challenged by many academic researchers.In the last few years a generic model of which the CAPM is said to be a sub-set, the Arbitrage Pricing Model (APM), has received increasing attention by academics. This paper is an overview of the developments in the pricing of financial assets.

Arbitrage Pricing Model: A Critical Examination of Its Empirical Applicability For the London Stock Exchange

Arbitrage Pricing Model: A Critical Examination of Its Empirical Applicability For the London Stock Exchange

An International Arbitrage Pricing Model with PPP Deviations

This paper develops an intertemporal, international asset pricing model for use in applied theoretical and empirical research. An important feature of the model is that it incorporates both stochastic inflation rates and stochastic Purchasing Power Parity deviations (PPP). The model derives the equilibrium real return on assets, and obtains empirically tractable reduced form equations which can be used to examine such issues as capital market segmentation, currency substitution, exchange rate volatility, and the forward exchange market's risk premium. Mechanically, the model begins as a system of stochastic differential equations which describe the dynamic paths of a vector of state variables, prices, and PPP deviations. The state variables' intertemporal development determines the production and credit opportunities, and provides the model's fundamental dynamic nature. The model is shown to be consistent with the domestic-general equilibrium asset pricing models of Cox, Ingersoll, and Ross (1985) and Brock (1982). The model is applied to pricing forward exchange, and an empirically tractable equation of the risk premium is derived which will allow researchers to uncover the risk premium's economic determinants.