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In finance, arbitrage pricing theory (APT) is a multi-factor model for asset pricing which relates various macro-economic (systematic) risk variables to the pricing of financial assets. Proposed by economist Stephen Ross in 1976, [ 1 ] it is widely believed to be an improved alternative to its predecessor, the capital asset pricing model (CAPM ...
An estimation of the CAPM and the security market line (purple) for the Dow Jones Industrial Average over 3 years for monthly data. In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.
[10] [11] The CAPM, for example, can be derived by linking risk aversion to overall market return, and restating for price. [9] Black-Scholes can be derived by attaching a binomial probability to each of numerous possible spot-prices (i.e. states) and then rearranging for the terms in its formula. See Financial economics § Uncertainty.
In mathematical finance, multiple factor models are asset pricing models that can be used to estimate the discount rate for the valuation of financial assets; they may in turn be used to manage portfolio risk.
The difference between the agreed price and the amount repaid (i.e. owed) is the arbitrage profit. (b) where the discounted future price is lower than today's price: The arbitrageur agrees to pay for the asset on the future date (i.e. buys forward) and simultaneously sells the underlying today; he invests (or banks) the proceeds.
The cost of equity is typically calculated using the CAPM, although other approaches such as APT are also used. The currency charge to be subtracted is then simply Equity Charge = Equity Capital x Cost of Equity, and Residual income = Net Income − Equity Charge.
The CAPM is a model that derives the theoretical required expected return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed:
In 2015, Fama and French extended the model, adding a further two factors — profitability and investment. Defined analogously to the HML factor, the profitability factor (RMW) is the difference between the returns of firms with robust (high) and weak (low) operating profitability; and the investment factor (CMA) is the difference between the returns of firms that invest conservatively and ...