UNIT IV Arbitrage Pricing Theory - PowerPoint Presentation

1. UNIT IVArbitrage Pricing TheoryDr. Pravin Kumar AgrawalAssistant ProfessorDepartment of Business ManagementPhD (Finance)

2. ArbitrageThe act of exploiting the price differences in a financial asset in different markets to make profits by simultaneously purchasing at a low price in one market and selling the same asset at a higher price in a different market. considered a risk free investment. The person who tries to profit from such arbitrage opportunity due to price imbalance is called an arbitrageur. 

3. Arbitrage Pricing TheoryA multi-factor asset pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to the capital asset pricing model (CAPM). Unlike the CAPM, which assume markets are perfectly efficient, APT assumes markets sometimes misprice securities, before the market eventually corrects and securities move back to fair value. Using APT, arbitrageurs hope to take advantage of any deviations from fair market value.

4. Arbitrage Pricing Theory (APT) is an alternate version of the Capital Asset Pricing Model (CAPM). This theory, like CAPM, provides investors with an estimated required rate of return on risky securities.In simple words, the Arbitrage Pricing Theory (APT) is a theory of multifactor asset pricing that states that an asset's expected returns are associated with a number of factors, risk being an important factor.APT describes a mechanism used by investors to identify an asset (such as a equity share) which is incorrectly priced. Investors can subsequently bring the price of the security back into alignment with its actual value.

5. Arbitrage Pricing TheoryAs per assumptions under Arbitrage Pricing Theory, return on an asset is dependent on various macroeconomic factors like inflation, exchange rates, production measures, changes in interest rates, movement of yield curves etc.

6. Arbitrage Pricing Theory: AssumptionsThe theory is based on the principle of capital market efficiency and hence assumes all market participants trade with the intention of profit maximization.It assumes no arbitrage exists and if it occurs participants will engage to benefit out of it and bring back the market to equilibrium levels.It assumes markets are frictionless, i.e. there are no transaction costs, no taxes, short selling is possible and an infinite number of securities is available.

7. Calculating the Expected Rate of Return of an Asset Using Arbitrage Pricing Theory (APT)  Arbitrage Pricing Theory is given as E(R) = Risk Free Rate (rf) + b1 * (factor 1) +b2 *(factor 2) + ….+ bn *(factor n) E(R) = Expected rate of return on the risky assetRf = Risk-free interest rate b = Sensitivity of the stock with respect to the factor; referred as beta

8. ExampleThe following four factors have been identified as explaining a stock's return and its sensitivity to each factor and the risk premium associated with each factor have been calculated: Gross domestic product (GDP) growth: ß = 0.6, Risk Premium = 4% Inflation rate: ß = 0.8, RP = 2% Gold prices: ß = -0.7, RP = 5% S &P’s 500 index return: ß = 1.3, RP = 9% The risk-free rate is 3% Using the APT formula, the expected return is calculated as: Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%Source: https://www.investopedia.com/terms/a/apt.asp, accessed on 20.4.22

9. Arbitrage Pricing TheoryAs the formula shows, the expected return on the asset/stock is a form of linear regression taking into consideration many factors that can affect the price of the asset and the degree to which it can affect it i.e. the asset’s sensitivity to those factors.If one is able to identify a single factor which singly affects the price, the CAPM model shall be sufficient. If there is more than one factor affecting the price of the asset/stock, one will have to work with a two-factor model or a multi-factor model depending on the number of factors that affect the stock price movement for the company.

10. AdvantagesAPT model is a multi-factor model. So, the expected return is calculated taking into account various factors and their sensitivities that might affect the stock price movement. Thus, it allows the selection of factors that affect the stock price largely and specifically.The APT model does not require any assumption about the empirical distribution of the asset returns, unlike CAPM which assumes that stock returns follow a normal distribution and thus APT a less restrictive model.

11. Arbitrage Pricing Theory: LimitationsThe model requires a short listing of factors that impact the stock under consideration. Finding and listing all factors can be a difficult task and runs a risk of some or the other factor being ignored. Also, the risk of accidental correlations may exist which may cause a factor to become substantial impact provider.The model requires calculating sensitivities of each factor which again can be an difficult task and may not be practically feasible.The factors that affect the stock price for a particular stock may change over a period of time. Moreover, the sensitivities associated may also undergo shifts which need to be continuously monitored making it very difficult to calculate and maintain.

12. Behavioral FinanceBehavioral finance is the study of investors’ psychology while making investment decisionsBehavioral finance is a field of study that tries to identify and explain biases that cause people to make irrational investment decisions or behave in financially detrimental waysBlending together psychology and finance

13. Behavioral FinanceBehavioral Finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets.For example, people use past performance as the best predictor for future performance and often invest in the mutual funds with the best five-year track records. These rules are likely to be faulty and generally lead to poor decisions. Relying on such heuristics is called ‘Heuristic Bias’.

14. BEHAVIOURAL FINANCE DefinitionW. Forbes (2009) defined behavioral finance as a science regarding how psychology influences financial market. This view emphasizes that the individuals are affected by psychological factors like cognitive biases in their decision-making, rather than being rational and wealth maximizing.

15. MEANING OF BEHAVIOURAL FINANCEIt focuses on the fact that investors are not always rational, have limits to their self-control, and are influenced by their own biases.

16. MEANING OF BEHAVIOURAL FINANCEBehavioral finance attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, therefore, have unpredictable consequences. This is in contrast to many traditional theories which assume investors make rational decisions.

17. MEANING OF BEHAVIOURAL FINANCEBehavioral finance biases often lead people to make illogical or detrimental investment decisions.Understanding financial behavior biases can help people make more rational moves with their money.

18. MEANING OF BEHAVIOURAL FINANCEWhy do even experienced investors buy too late - and then sell too soon?Why do companies with stock symbols that come earlier in the alphabet have a small but measurable advantage over those that come later?Why do people refuse to withdraw money from a savings account, even when they are drowning in debt?

19. DefinitionBehavioral finance is that discipline of behavioral economics which analyzes the impact of human psychology on the investors’ actions. Thus, ultimately shaping the investing decisions of individuals, directors, managers, analysts, advisors, researchers, speculators and other market players.Behavioral finance contradicts the theory of traditional finance. This phenomenon considers human beings as normal and irrational at times. Hence, it brings forward the consequences of personal biases over investment decisions.Human beings are emotional and tend to make cognitive mistakes resulting in false decision-making.

20. Need of BEHAVIOURAL FINANCEResearch studies have revealed that psychological biases such as emotions, fear, over- confidence, greed, and risk aversion influence investors’ behaviour that, in turn, influences stock markets. As such, there is a need for studying and understanding behavioral finance to exploit investors’ psychology for profits.

21. Foundation of Behavioral FinanceThe theory of behavioral finance is based on the following three criteria: Psychology: In behavioral finance, we study the impact of a person’s attitude, emotions and mindset over his/her investing decisions. Sociology: It emphasizes the effect of social relations and the conduct of an individual while being in a group or a society over his/her decision-making ability. Finance: The sum available with the investor, price and future value of the security also influences the capital allocation functions.

22. Behavioral Finance ConceptsWhen we look forward to smart investment decision-making, we should be aware of the various perceptions of behavioral finance. These are thoroughly explained below:

23. Herd BehaviourPeople tend to follow the investing pattern of the other investors or say the crowd to bring about the major economic fluctuations.For instance; when a piece of negative news about a stock is reported, the investors start selling off their holdings altogether resulting in price contraction.

24. Mental AccountingThe human nature of pre-allocating the available funds for a definite purpose due to their intuitive approach, adversely affect their investing decisions.For instance; keeping the excess money in savings account rather than in fixed deposit, to ensure easy withdrawal whenever required.

25. AnchoringMany a time investors’ decision-making processes rely upon their psychological benchmark misleading through irrelevant information. In this process, sometimes the actual value or the future profit which the security may yield is overlooked.For instance; people deciding to spend up to a certain level or signifying the purchase price of the stock.

26. Emotional GapMost of the times, investors fail to become rational while decision making. The emotions of fear, anxiety, panic, anger and excitement take over the process of investment decision making.For instance; many people got excited seeing the performance of bitcoins and blindly invested in it, finally losing their money.

27. CHARACTERISTICS OF BEHAVIOURAL FINANCE Heuristics Framing Emotions Market Impact

28. HEURISTICSHeuristics are referred as rule of thumb, which applies in decision making to reduce the cognitive resources to solve a problem. These are mental shortcuts that simplify the complex methods to make a judgment. Investor as decision maker confronts a set of choices within certainty and limited ability to quantify results. This leads identification and understanding of all heuristics that affect financial decision making. Some of heuristics are representativeness, anchoring & adjustments, familiarity, overconfidence, regret aversion, conservatism, mental accounting, availability, ambiguity aversion and effect. Heuristics help to make decision.

29. FRAMINGThe perceptions of choices that people have are strongly influenced by how these choices are framed. It means choices depend on how question is framed, even though the objective facts remain constant. Psychologists refer this behaviour as a’ frame dependence’. Investors forecast of the stock market depends on whether they are given and asked to forecast future prices or future return. So it is how framing has adversely affected people’s choices.

30. EMOTIONSEmotions, fantasies and fears drive much decision of human beings.

31. MARKET IMPACTDo the Cognitive errors and biases of individuals and groups of people affect market and market prices? Indeed, main attraction of behavioural finance field was that market prices did not appear to be fair. How market anomalies fed an interest in the possibility that they could be explained by psychology? Standard finance argues that investors’ mistakes would not affect market prices because when prices deviate from fundamental value, rational investor would exploit the mispricing for their own profit. But who are those who keep the market efficient? Even institutional investor exhibits the inefficiency. And other limit to this is arbitrage.

32. NATUREBehavioral Finance is just not a part of finance. It is something which is much broader and wider and includes the insights from behavioral economics, psychology and microeconomic theory.

33. BRANCHES OF BEHAVIOURAL FINANCEMicro Behavioral Finance: – This deals with the behaviour of individual investors. – In this the irrational investors are compared to rational investors.Macro Behavioral Finance: – This deals with the drawbacks of efficient market hypothesis. – EMH is one of the models in conventional finance that helps us understand the trend of financial markets.

34. OBJECTIVES OF BEHAVORIAL FINANCECorrect decision making Provide knowledge to unaware investors Identifies emotions and mental errors Delivering what the client expects Ensuring mutual benefits Maintaining a consistent approachExamining a consistent approach

35. BEHAVIOURAL FINANCE AS SCIENCE AS WELL AS AN ART

36. Behavioural Finance as a ScienceScience is a systematic and scientific way of observing, recording, analysing and interpreting any event. Behavioural Finance has got its inputs from traditional finance which is a systematic and well-designed subject based on various theories. On this basis behavioural finance can be said to be a science. The theories of standard finance also helps in justifying the price movements and trends of stocks (Fundamental Analysis), the direction of market (Technical Analysis), construction, revision and evaluation of investors’ portfolios( Markowitz Model, Sharpe’s Performance Index, Treynor’s Performance Index, various formula and plans of portfolio revision)

37. Behavioral Finance as an ArtIn art we create our own rules and not work on rules of thumb as in science.Art helps us to use theoretical concepts in the practical world. Behavioural finance focuses on the reasons that limit the theories of standard finance and also the reasons for market anomalies created. It provides various tailor made solutions to the investors to be applied in their financial planning. Based on above behavioural finance can be said to be an art of finance in a more practical manner. It also helps to guide the investors to identify themselves better by providing various models of human personality.

38. SCOPE OF BEHAVIOURAL FINANCETo understand the Reasons of Market Anomalies: though standard finance theories are able to justify the stock markets to a great extent, still there are many market anomalies that takes place in the stock market, like creation of bubbles, the effect of any event, calendar effect on stock market and trade etc. these market anomalies remain unanswered in standard finance but behavioural finance provides explanations and remedial actions to various market anomalies. To Identify Investor’s Personalities: study of behavioural finance helps in identifying the different type of investors personality. Once the biases of the investor’s actions are identified, by the study of investor’s personality, Various new financial instruments can be developed to hedge unwanted biases created in financial markets.

39. SCOPE OF BEHAVIOURAL FINANCEHelps to identify the risks and their hedging strategies: because of various anomalies in the stock market, investments these days are not only exposed to the identified risks, but also to the uncertainty of the returns. Provides an explanation to various corporate activities: behavioural Finance provides explanations on the behaviour of the investors towards a stock once the dividend has been declared or Effect of good or bad news, stock split, dividend decision etc.

40. SCOPE OF BEHAVIOURAL FINANCETo enhance the skill set of investment advisors: It can be done by better understanding of investor’s goal, maintaining a systematic approach to advise, earn the expected return and maintain win-win situation for both the client and the advisors.

41. Scope of Behavioral FinanceBehavioral finance has proved to be highly relevant for the individuals, managers, financial advisors, market speculators, teachers, analysts and many others.

42. Significance of Behavioral FinanceInvestors: Behavioral finance is a means to analyze the common mistakes which the investors make while selecting particular security. It enlightens upon on the common biases which restrict people to make rational investment decisions.Corporations: In the context of companies, the behavioral finance studies the impact of the mindset of financial advisors, directors and managers that influence corporate investment decisions.

43. Significance of Behavioral FinanceMarkets: When it comes to stock price analysis and speculation, behavioral finance trends are widely applicable. Since the experts believe that the stock market is not completely efficient, the efficient market hypothesis (EMH) cannot work independently.Regulators: The financial regulators consider behavioral finance as a means to refrain market failure and future crisis by transforming the market players’ attitude towards certain security.

44. Scope of Behavioral FinanceEducators: For the educators and teachers behavioral finance helps to depart knowledge on rational decision making and elaborating the psychological barriers which hinder the process.

45. SIGNIFICANCE OF BEHAVORIAL FINANCEDefines investors’ biases Manages behavioral biases Helps in investment decisions Helps for financial advisors’ and fund managers Signifies that investors are emotional

46. Difference between traditional finance and Behavioral FinanceThe traditional finance theories are based on certain assumptions. These are investors are rational, the market is efficient, investors form their portfolio based on the mean-variance rule and the expected return are the function of the risk. Behavioural finance criticized each and every assumption saying that investors are normal or irrational, the market is not efficient, investors do not construct their portfolio based on mean-variance and risk is not the function of the expected return.

47. Difference between traditional finance and Behavioral FinanceTraditional finance assumes that people are guided by reasons and logic and independent judgment. While, behavioral finance, recognizes that emotions and herd instincts play an important role in influencing decisions.Traditional finance assumes that people process data appropriately and correctly. In contrast, behavioral finance recognizes that people employ imperfect rules of thumb (heuristics) to process data which induces biases in their belief and predisposes them to commit errors.

48. Understanding Behavioral Finance Biases Self-attribution biasOur successes are caused by our skills, knowledge and hard work, but our failures are caused by someone else or bad luck“ People do not learn from their past failures and mistakes! Real life example Failing to pass an important exam Investing • Successful and unsuccessful stock picks How to make better decisions? Investing – Write down detailed records of your investment decisions and actions Try to be as frank as possible to yourself, try to avoid any regrets Analyze current decisions and results of past decisions in consistent and open way

49. Understanding Behavioral Finance BiasesConfirmation bias: Confirmation bias is the tendency of people to pay close attention to information that confirms their belief and ignore information that contradicts it. This is a type of bias in behavioral finance that limits our ability to make objective decisions. Example: Mr. X talks to a real estate agent who agrees that home prices will rise.  He then decides to increase his portfolio allocation to real estate to 90% but soon after, the market goes down.

50. Representative bias  Where individuals use past experiences to interpret new information. Consequently, investors may make decisions based on a small sample that results in more frequent trading, reducing returns.Example: Mr. X is invested in Manager A whose short-term performance (1, 2, and 3-year returns) have underperformed its benchmark. He decides to replace this fund with Manager B who has outperformed over the same period. At the end of the year, Manager A starts to outperform Manager B.

51. Loss AversionWhen the investor has previously gone through the trauma of losing a huge amount, his/her investing decision is overshadowed by this past experience. Thus, the investor focuses more on minimizing loss and holds the stock irrelevantly for a long period, as a result of loss aversion.Loss-aversion bias, where the thought of losing outweighs potential gains. Investors may reduce their upside potential by selling winners and holding losers.Example: Mr. X is invested in stock A which has a large unrealized loss. As the price continues to drop, he decides to hold the stock in hopes of breaking even. The stock subsequently never reaches her purchase price.

52. Framing BiasFraming bias occurs when people make a decision based on the way the information is presented, as opposed to just on the facts themselves. The same facts presented in two different ways can lead to different judgments or decisions from people. Whatever data about the security is framed in front of the investors, they find to be real and depends upon it for their taking investment decision. Framing Bias, where a person answers a question differently, based on how it’s asked.Example: Mary has a low-risk tolerance and meets with an advisor who offers two funds; one that has a 10% chance of loss and the other that has a 90% chance of not losing. She chooses the latter even though both funds have the same probability of loss.

53. Understanding Behavioral Finance BiasesOverconfidence bias is a false and misleading assessment of our skills, intellect, or talent. In short, it's an egotistical belief that we're better than we actually are. It can be a dangerous bias and is very prolific in behavioral finance and capital markets. Investors may choose stocks with little supporting evidence and consequently underperform the markets.Example: Mr. X actively trades tech stocks as she believes she can select undervalued securities. Though some of her stocks yield high returns, his net returns are lower than the market because of trading costs associated with frequent trading.

54. Herding MentalityHerd mentality bias refers to investors' tendency to follow and copy what other investors are doing. They are largely influenced by emotion and instinct, rather than by their own independent analysis. This guide provides examples of herd bias. We are hard-wired to herd. Going against the crowd / non-conformity triggers fear in people.

55. Self-control biasWhere individuals put their short-term needs ahead of long-term goals. Investors may not have enough saved for future goals such as retirement and may resort to riskier assets to generate more income

56. Experiential BiasSometimes the investor frames their decision around a prior event and assumes that the same thing will repeat in future also.Therefore, the person follows his/her belief to invest or not to invest in a certain stock, ending up being experientially biased towards it.

57. Narrative FallacyA security wrapped up with a nice story is easily sellable to those who fantasize more on stories rather than the facts. Hence, such investors often make mistake landing upon the stocks which look promising but fails to perform as expected.

58. Conservatism bias Where individuals maintain prior views by not acting on new information. Consequently, investors risk holding onto a security longer than a “rational” investor.Example: Paul has most of his portfolio invested in direct real estate since he believes house prices will rise — despite recent reports supporting a downturn.

59. Mental accounting biaswhere individuals value money differently based on its source.Example: Mary receives her tax refund that she perceives as “free money”. She spends the refund on a lavish vacation instead of placing it in her savings account, which is where she usually deposits her income.

60. Overcoming Behavioral Finance Issues

61. 1.  Focus on the Process There are two approaches to decision-making:Reflexive – Going with your gut, which is effortless, automatic and, in fact, is our default option, The emotional approach to decision making that is automatic, effortless, and the default option.Reflective – Logical and methodical, but requires effort to engage in actively, The logical approach to decision-making. Relying on reflexive decision-making makes us more prone to deceptive biases and emotional and social influences. Establishing logical decision-making processes can help protect you from such errors. Get yourself focused on the process rather than the outcome. If you’re advising others, try to encourage the people you’re advising to think about the process rather than just the possible outcomes. Focusing on the process will lead to better decisions because the process helps you engage in reflective decision-making.

62. 2. Prepare, Plan and Pre-CommitBehavioral finance teaches us to invest by preparing, by planning, and by making sure we pre-commit. 

63. Overcoming Behavioral Finance IssuesBefore buying a stock or mutual fund, decide just how much it would have to go down or up before you'd sell it. This could help keep you from holding on too long if it falls, or getting too anxious to sell as soon as it rises. Creating a long-term financial plan will also help keep distracting emotions at bay.

64. Overcoming Behavioral Finance IssuesSince losses hurt more than gains. Make us feel good, accentuate the negative when thinking about saving and investing. Keep track of the decisions you made about money, and why you made them. Then revisit them in a year. Seeing how much indecision you had to deal with in the past (as well as seeing what you got wrong) will prevent overconfidence in your future investing decisions.

65. How to deal with behavioral financial biasesTry getting out of your bubble: If almost everyone you're exposed to is doing the same thing and pursuing the same investments, they may of course be right. But think of how much more certain you'll be if, instead of just following the crowd, you actively seek out resisting views and strategies. Don't blindly follow investing trends - buying a stock just because it's hot.

66. How to deal with behavioral financial biasesBehavioral finance tries to measure the miscalculations and misguided moves that people make with their money. The idea "is not that people are irrational, but that they are predictably irrational