6 Modern portfolio theory helps an investor to identify his optimal portfolio from umpteen number of security portfolios that can be constructed. Elaborate on Arbitrage Pricing Theory and principle of Arbitrage theory.
Answer:- Explanation of Arbitrage pricing theory
Capital Asset Pricing Model (CAPM), and Arbitrage Pricing Theory (APT) are two of the most commonly used models for pricing risky assets based on their relevant risks.
CAPM calculates the required rate of return for any risky asset based on the security’s beta. Beta is a measure of the movement of the security’s return with the return on the market portfolio, which includes all available securities and where the proportion of each security in the portfolio is its market value as a percentage of total market value of all securities.
The problem with CAPM is that such a market portfolio is hypothetical and not observable and we have to use a market index like the S&P 500 or Sensex as a proxy for the market portfolio. However, indexes are imperfect proxies for overall market as no single index includes all capital assets, including stocks, bonds, real estate, collectibles, etc. Besides, the indexes do not fully capture the relevant risk factors in the economy.
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