Definition of Arbitrage Pricing Theory (APT)

Arbitrage Pricing Theory (APT)

An alternative model to the capital asset pricing model developed by
Stephen Ross and based purely on arbitrage arguments.

Administrative pricing rules

IRS rules used to allocate income on export sales to a foreign sales corporation.

Agency theory

The analysis of principal-agent relationships, wherein one person, an agent, acts on behalf of
anther person, a principal.

Arbitrage

The simultaneous buying and selling of a security at two different prices in two different markets,
resulting in profits without risk. Perfectly efficient markets present no arbitrage opportunities. Perfectly
efficient markets seldom exist.

Arbitrage-free option-pricing models

Yield curve option-pricing models.

Arbitrageurs

People who search for and exploit arbitrage opportunities.

Asset pricing model

A model for determining the required rate of return on an asset.

Asset pricing model

A model, such as the Capital Asset pricing Model (CAPM), that determines the required
rate of return on a particular asset.

Binomial option pricing model

An option pricing model in which the underlying asset can take on only two
possible, discrete values in the next time period for each value that it can take on in the preceding time period.

Black-Scholes option-pricing model

A model for pricing call options based on arbitrage arguments that uses
the stock price, the exercise price, the risk-free interest rate, the time to expiration, and the standard deviation
of the stock return.

Bubble theory

Security prices sometimes move wildly above their true values.

Call swaption

A swaption in which the buyer has the right to enter into a swap as a fixed-rate payer. The
writer therefore becomes the fixed-rate receiver/floating rate payer.

Capital asset pricing model (CAPM)

An economic theory that describes the relationship between risk and
expected return, and serves as a model for the pricing of risky securities. The CAPM asserts that the only risk
that is priced by rational investors is systematic risk, because that risk cannot be eliminated by diversification.
The CAPM says that the expected return of a security or a portfolio is equal to the rate on a risk-free security
plus a risk premium.

Covered interest arbitrage

A portfolio manager invests dollars in an instrument denominated in a foreign
currency and hedges his resulting foreign exchange risk by selling the proceeds of the investment forward for
dollars.

Currency arbitrage

Taking advantage of divergences in exchange rates in different money markets by
buying a currency in one market and selling it in another market.

Garmen-Kohlhagen option pricing model

A widely used model for pricing foreign currency options.

Index arbitrage

An investment/trading strategy that exploits divergences between actual and theoretical
futures prices.

Liquidity theory of the term structure

A biased expectations theory that asserts that the implied forward
rates will not be a pure estimate of the market's expectations of future interest rates because they embody a
liquidity premium.

Local expectations theory

A form of the pure expectations theory which suggests that the returns on bonds
of different maturities will be the same over a short-term investment horizon.

Market segmentation theory or preferred habitat theory

A biased expectations theory that asserts that the
shape of the yield curve is determined by the supply of and demand for securities within each maturity sector.

Modern portfolio theory

Principles underlying the analysis and evaluation of rational portfolio choices
based on risk-return trade-offs and efficient diversification.

Normal backwardation theory

Holds that the futures price will be bid down to a level below the expected
spot price.

One-factor APT

A special case of the arbitrage pricing theory that is derived from the one-factor model by
using diversification and arbitrage. It shows the expected return on any risky asset is a linear function of a
single factor.

Preferred habitat theory

A biased expectations theory that believes the term structure reflects the
expectation of the future path of interest rates as well as risk premium. However, the theory rejects the
assertion that the risk premium must rise uniformly with maturity. Instead, to the extent that the demand for
and supply of funds does not match for a given maturity range, some participants will shift to maturities
showing the opposite imbalances. As long as such investors are compensated by an appropriate risk premium
whose magnitude will reflect the extent of aversion to either price or reinvestment risk.

Pricing efficiency

Also called external efficiency, a market characteristic where prices at all times fully
reflect all available information that is relevant to the valuation of securities.

Pure expectations theory

A theory that asserts that the forward rates exclusively represent the expected
future rates. In other words, the entire term structure reflects the markets expectations of future short-term
rates. For example, an increasing sloping term structure implies increasing short-term interest rates. Related:
biased expectations theories

Put swaption

A financial tool in which the buyer has the right, or option, to enter into a swap as a floatingrate
payer. The writer of the swaption therefore becomes the floating-rate receiver/fixed-rate payer.

Regulatory pricing risk

Risk that arises when regulators restrict the premium rates that insurance companies
can charge.

Risk arbitrage

Speculation on perceived mispriced securities, usually in connection with merger and
acquisition deals. Mike Donatelli, John Demasi, Frank Cohane, and Scott Lewis are all hardcore arbs. They
had a huge BT/MCI position in the summer of 1997, and came out smelling like roses.

Risk controlled arbitrage

A self-funding, self-hedged series of transactions that generally utilize mortgage
securities as the primary assets.

Riskless arbitrage

The simultaneous purchase and sale of the same asset to yield a profit.

Static theory of capital structure

theory that the firm's capital structure is determined by a trade-off of the
value of tax shields against the costs of bankruptcy.

Structured arbitrage transaction

A self-funding, self-hedged series of transactions that usually utilize
mortgage securities as the primary assets.

Swaption

Options on interest rate swaps. The buyer of a swaption has the right to enter into an interest rate
swap agreement by some specified date in the future. The swaption agreement will specify whether the buyer
of the swaption will be a fixed-rate receiver or a fixed-rate payer. The writer of the swaption becomes the
counterparty to the swap if the buyer exercises.

Triangular arbitrage

Striking offsetting deals among three markets simultaneously to obtain an arbitrage profit.

Two-state option pricing model

An option pricing model in which the underlying asset can take on only two
possible (discrete) values in the next time period for each value it can take on in the preceding time period.
Also called the binomial option pricing model.

Underpricing

Issue of securities below their market value.

Yield curve option-pricing models

Models that can incorporate different volatility assumptions along the
yield curve, such as the Black-Derman-Toy model. Also called arbitrage-free option-pricing models.

Cost-plus pricing

A method of pricing in which a mark-up is added to the total product/service cost.

Target rate of return pricing

A method of pricing that estimates the desired return on investment to be achieved from the
fixed and working capital investment and includes that return in the price of a product/service.

Capital Asset Pricing Model (CAPM)

A model for estimating equilibrium rates of return and values of
assets in financial markets; uses beta as a measure of asset risk
relative to market risk

dual pricing arrangement

a transfer pricing system that allows
a selling division to record the transfer of goods or
services at one price (e.g., a market or negotiated market
price) and a buying division to record the transfer at another
price (e.g., a cost-based amount)

theory of constraints (TOC)

a method of analyzing the bottlenecks
(constraints) that keep a system from achieving
higher performance; it states that production cannot take
place at a rate faster than the slowest machine or person
in the process

Arbitrage

The purchase of securities on one market for immediate resale on
another market in order to profit from a price or currency discrepancy.

Swaption

A swap option; an option on an interest-rate swap. The option gives
the holder the right to enter into a contracted interest-rate swap at a specified
future date. See Swap.

capital asset pricing model (CAPM)

theory of the relationship between risk and return which states that the expected risk
premium on any security equals its beta times the market risk premium.

expectations theory of exchange rates

theory that expected spot exchange rate equals the forward rate.

pecking order theory

Firms prefer to issue debt rather than equity if internal finance is insufficient.

random walk theory

Security prices change randomly, with no predictable trends or patterns.

trade-off theory

Debt levels are chosen to balance interest tax shields against the costs of financial distress.

underpricing

Issuing securities at an offering price set below the true value of the security.

Arbitrage

Transactions designed to make a sure profit from inconsistent prices.

Quantity Theory of Money

theory that velocity is constant, and so a change in money supply will change nominal income by the same percentage. Formalized by the equation Mv = PQ.

Real Business Cycle Theory

Belief that business cycles arise from real shocks to the economy, such as technology advances and natural resource discoveries, and have little to do with monetary policy.

Captive Agent

A licensed insurance agent who sells insurance for only one company.

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