Arbitrage Pricing Policy

Posted in Finance, Accounting and Economics Terms, Total Reads: 1305
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Definition: Arbitrage Pricing Policy

It is an asset pricing model where the expected returns of an asset are linearly related to common risk factors – macro-economic factors or theoretical market indices and company-specific factors – where the sensitivity to changes in the factors is represented by a factor-specific beta coefficient. In simple terms, the price of an asset is derived by a number of external factors.

Formula:

r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅⋅

Where,

r = expected return on the security
rf = risk-free rate
f = separate factor
β = relationship between the asset and the factor

The formula is strikingly similar to the Capital Asset Pricing Model (CAPM). The difference between the CAPM and the Arbitrage Pricing Policy is that the CAPM has a single non-company factor and a single beta, on the other hand, the Arbitrage Pricing Policy separates out non-company factors into as many factors as are required. This means more betas are to be calculated with no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM.

Example: The Arbitrage Pricing Policy is used to estimate the value of securities, especially when security-specific factors are involved (inflation, etc.)


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