Arbitrate Pricing Theory (ATP) is a model used in evaluating the assets of a business. This paper will appraise Arbitrage Pricing Theory (APT) considering the number of systematic factors involved. The paper also identifies the factors that should be considered in determining the risk premium of an asset using in the APT model.
Arbitrage Pricing Theory is a widely known method of estimating asset price basing on systematic risk, macroeconomic factors, and other security-specific factors (Burzoni et al., 2016). Macroeconomic factors are reliable predictors to the asset pricing and it directly affects systematic risks. Systematic risks include random changes in inflation, yield curve, corporate bonds, gross domestic products, markets indices, and the gross national products to mention but a few. Since such factors are wide and analyzing all of them can be challenging, only four or five significant factors are enough to determine asset pricing. It is therefore correct to state that for APT to be useful, the systematic risk number should be small. According to Burzoni et al. (2016) the relevant nature of the systematic risks will provide a base for conducting APT without involving other less significant systematic risk factors.
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The CAPM theory only considers market risk while conducting the asset risk premium (Cai, Clacher & Keasey, 2013). Contrarily, ATP does not indicate the factors that should be considered in determining an asset’s risk premium. However, the most significant factors should be included in determining the risk premium of an asset. The considerations involved in determining risk premiums should focus on the nature and state of the company and its ability to pay off any loss that may incur (Goetzmann & Ibbotson, 2006). For instance, company size can be considered as a risk factor since the company’s ability to manage and pay its debt is a vital aspect before engaging in risk premium assets.
The larger the company the easier it becomes to acquire assets which may offer good returns. Additionally, larger companies are in better positions to compensate their investors in case the investment becomes futile. The APT model widely employs company size as a risk factor since it reflects the company’s ability to finance and compensate investments especially due to their reliable managerial and financial capabilities.
Conclusion
The Arbitrage Pricing Theory (APT) is a theory that is widely used in determining the price of assets. Since it involves a wide range of factors and considerations, reducing the number to less but significant factors plays a big role in making ATP a useful theory.
References
Burzoni, M., Frittelli, M., Hou, Z., Maggis, M., & Obłój, J. (2016). Pointwise Arbitrage Pricing Theory in Discrete Time. Retrieved from http://165.193.178.96/login?url=http%3a%2f%2fsearch.ebscohost.com%2flogin.aspx%3fdirect%3dtrue%26db%3dedsarx%26AN%3dedsarx.1612.07618%26site%3deds-live
Cai, C. X., Clacher, I., & Keasey, K. (2013). Consequences of the Capital Asset Pricing Model (CAPM)-a Critical and Broad Perspective. ABACUS -SYDNEY THEN OXFORD- , (SUPP/1), 51. Retrieved from http://165.193.178.96/login?url=http%3a%2f%2fsearch.ebscohost.com%2flogin.aspx%3fdirect%3dtrue%26db%3dedsbl%26AN%3dRN324454390%26site%3deds-live
Goetzmann, W. N., & Ibbotson, R. G. (2006). The Equity Risk Premium : Essays and Explorations . Oxford: Oxford University Press. Retrieved from http://165.193.178.96/login?url=http%3a%2f%2fsearch.ebscohost.com%2flogin.aspx%3fdirect%3dtrue%26db%3dnlebk%26AN%3d179894%26site%3deds-live
