Advantages Of Arbitrage Pricing Theory

1.3.3 Arbitrage Pricing Theory (APT)

As financial analysts seek to find solutions to financial problems and also why assets are priced differently, theories keep on coming into existence. And as a traceable framework of the underline principle of capital asset pricing in security market (Koch, 2009), Ross (1976a, 1976b) developed APT with the strand that investors believe the stochastic properties of returns of capital assets are consistent with a factor configuration. Fixating on the returns of capital asset as modeled by a factor structure, Arbitrage Pricing Theory in which prevention of arbitrage over static portfolios of these assets leads to a ‘linear relationship’ between expected return and its related covariance (risk of an investment

Evidences show that the two models differ substantially in their assumptions even though they might share certain attributes such as using assumptions to substantiate how assets should be priced. While CAPM is concerned with the finding of equilibrium of the market by holding optimal portfolio as suggested by the portfolio theory, APT adheres to the finding of the same equilibrium but by ruling out arbitrage possibilities (Krause, 2001). It therefore allows the inclusion of other sources either than market risk. As Fama and French (1992; 1993) asserted that other variables are even able to explain the observed returns or changes in the stock prices better than the market risk and could therefore be a framework to find a justification of these changes on a sound theoretical

Over the years the relationship between macroeconomic variables and the stock price(s) has brought up controversies among scholars (Bukonla and Akinwande, 2012) base on disparities in views and security market conditions. The stand that certain fundamental macroeconomic variables affect or determine stock price (Ikoku, 2007; Maku and Atanda, 2009) clearly justifies the believe investors still have that monetary policy and macroeconomic events have a huge impact on the instability of the stock price (Bukonla and Akinwande, 2012). Attempts have been made to unveil factors that have ability to affect stock prices yet such factors are numerous and vast (Oseni, 2009). Changes in Stock price as the consequences of changes in both microeconomic and macroeconomic variables are highly supported by the thrived literature (Al-Shubiri, 2010). Critics of capital or security market have argued that liquidity of stock market negatively influence corporate governance, because highly liquid stock market breeds investors myopia (Al-Shubiri, 2010). Since investors are at ease to sell their equity or shares, highly liquid stock markets is capable of limiting investors’ ability to exert corporate control on their shares (Bhide, 1994). These problems according to Al-Shubiri (2010) are further magnified in emerging countries with less regulatory systems and high volatility of