Philippine E-Journals

The Arbitrage Pricing Theory and Common Stock Returns

Pablo F. Mangaran Jr.

 

Abstract:

The major assumption of the theory is that the returns of a large number of assets can be broken into two components: (1) the systematic risk which is non-diversifiable and which can be measured as exposure to a small number of common factors; and (2) the unsystematic or the idiosyncratic risk which can be eliminated through efficient portfolio diversification. From the major assumption, both the CAPM and the APT recognize that every asset must be compensated only according to its systematic risk. There are two major differences, however. (a) In the CAPM, the systematic risk of an asset is defined to be its covariability with the market portfolio. In the APT, the systematic risks are defined to be the co variability with several economic/financial factors. (b) The CAPM requires the economy to be in equilibrium while the APT requires only that the economy has no arbitrage opportunities.

 

The APT is a relatively new and different approach to determining asset prices. Considered as a more general and flexible theory than the CAPM, the APT suggests that multiple factors are involved in the return generating process. The major objectives of this study are: (1) to test the applicability of the APT using common stock returns traded in the country’s Manila Stock Exchange; and (2) to present the different theoretical and empirical issues surrounding the subject matter