Arbitrage Pricing Model; Determining the Number of Factors and Their Consistency Across Markets

Abstract

Purpose - The discovery of a true financial equilibrium model that could explain the prices of stocks has long been a sought after challenge and a vital area of research in modern financial theory. The concept is based on the fact that the price of the stock is affected by the present value of the future cash flows from the stock, and anything that will affect the discount rate of these future cash flows. Many brokerage firms, financial institutions and financial consulting firms use multi-index models to aid in the investment process Thus the APT model is becoming increasingly popular and has been a subject of several empirical studies. These models have been tested on both developed and developing markets. The purpose of this research is to analyze the Arbitrage Pricing Theory (APT) introduced by Ross (1976), which is a more simplified, multifactor model, with fewer relative assumptions to other models, across different representative markets, giving particular attention to the number of factors.

Design/methodology/approach – The research is quantitative in nature and principal component analysis will be used to determine the ideal number of factors that should be included in the model, as well as the identity of these factors.

Findings - Results indicate that the ideal number of factors vary from four to five factors across markets, with their identity differing across markets. Findings provide valuable insights for professionals in the market as well as academics who want to gain further knowledge on the number of factors.

Research limitations/implications –The application of Principal Component Analysis (PCA) is based only on a sample of stocks and not on the whole population in the stock market, and thus there remains a question of how accurate these approximations actually are.

Practical implications –The APT is a popular multi-index model that should be used by financial analysts to allow risk to be more tightly controlled and allow investors to protect against specific type of risk to which he or she is particularly sensitive or to make specific bets on certain types of risks.

Originality/value – No research has yet been carried out across different markets for the same time period as will be carried out in this research, and thus the empirical study in this research aims to add knowledge on whether the number of factors will be consistent across borders or will change from market to market.

Keywords Arbitrage Pricing Theory, Number of factors, Emerging markets

Paper type Research Paper