Find out how competition drive pricing can help businesses stay attractive to consumers without engaging in price wars. Explore the key aspects and benefits of this pricing strategy.
What is competition drive pricing?
Competition Drive Pricing is a pricing strategy where a company sets its prices based primarily on the prices charged by competitors rather than on its own costs or market demand. This approach involves closely monitoring competitors’ pricing and adjusting one’s own prices to remain competitive in the market.
Definition of Competition Drive Pricing
It is a pricing strategy where a company sets its product prices based on the prices set by competitors in the market. This approach focuses on gaining or maintaining market share by aligning prices with those of similar products or services offered by competitors. Businesses utilizing this strategy often react to price changes made by competitors in order to remain attractive to consumers while striving to avoid price wars.
Key aspects of competition drive pricing include:
Market Analysis: Businesses continuously analyze competitors’ pricing to determine the optimal price point for their products or services.
Price Matching: Some companies may adopt a policy of matching or slightly underpricing competitors to attract customers.
Dynamic Pricing: Pricing can be adjusted in real-time in response to changes in competitor prices.
While this strategy can help attract customers and maintain market share, it also carries risks, such as price wars that can erode profit margins.
Pros and Cons of Competition Drive Pricing
Pros or Advantages
Market Relevance: By aligning prices with competitors, businesses can remain relevant in a competitive market, ensuring they do not lose customers due to price discrepancies.
Customer Attraction: Lower pricing than competitors can attract price-sensitive customers, potentially increasing market share.
Simplicity: This pricing strategy provides a straightforward approach to pricing, as it relies on observable competitor prices rather than complex cost analyses.
Quick Adaptability: Companies can quickly adjust their prices in response to competitor moves, enabling them to remain competitive.
Enhanced Market Insight: Continuous monitoring of competitor pricing can provide valuable market insights, helping businesses understand market trends and consumer behavior.
Cons or Disadvantages
Profit Margin Erosion: Constantly matching or underpricing competitors can lead to reduced profit margins, impacting overall profitability.
Price Wars: Engaging in aggressive pricing strategies can spark price wars, where competitors continuously lower prices, damaging all parties involved.
Neglect of Value Proposition: Focusing solely on competitors’ prices can lead businesses to overlook their own unique value propositions, diminishing their brand identity.
Short-term Focus: This strategy may promote reactive rather than proactive pricing decisions, leading to missed opportunities for long-term growth.
Cost Structure Ignorance: Pricing decisions based on competitor prices may not take into account the company’s own costs, potentially leading to unsustainable pricing models.
Examples of Competition Drive Pricing
Competition drive pricing is prevalent across various industries. Here are a few examples demonstrating how companies implement this strategy:
1. Retail Sector
In the retail industry, companies like Walmart and Target often adjust their prices based on competitor offerings. If one store lowers the price on a product, others may follow suit to keep their sales competitive. For instance, if Target offers a popular brand of detergent at a lower price, Walmart may reduce their price accordingly to attract customers.
2. Airline Industry
Airlines frequently utilize competition drive pricing. If one airline announces a fare reduction for specific routes, other airlines on the same route may adjust their prices. For example, if Southwest Airlines lowers its fare for a flight to Cancun, airlines like American or Delta may respond with similar price cuts to avoid losing passengers.
3. Online Marketplaces
Platforms like Amazon use dynamic pricing strategies, which are influenced heavily by competitors. When one seller reduces their price for a particular gadget, Amazon’s algorithm may adjust the price of similar products in real-time to remain competitive. This allows Amazon to maintain its appeal to price-sensitive consumers.
4. Fast Food Industry
Restaurants often watch their competitors, especially during promotional periods. For instance, if McDonald’s launches a value menu promotion, Burger King may introduce its own limited-time offers to match McDonald’s, ensuring they attract the same clientele looking for budget-friendly options.
5. Telecommunications
Mobile service providers like Verizon, AT&T, and T-Mobile frequently monitor each other’s pricing plans. If T-Mobile introduces an attractive plan with lower rates, both Verizon and AT&T may revise their plans to match or beat T-Mobile’s offerings, thus retaining their customer base.
These examples illustrate how competition drive pricing helps businesses remain relevant and competitive in their respective markets while facing the inherent challenges associated with this strategy.
Unlock the power of competition based pricing. Find out how to set prices that attract customers while ensuring profitability in competitive industries.
What is competition based pricing?
Competition-based pricing is a pricing strategy where a company sets its prices primarily based on the prices of its competitors. This approach involves analyzing the market and considering how competitors are pricing similar products or services. The goal is to offer competitive prices that attract customers while still ensuring profitability.
Definition of Competition-Based Pricing
Competition-based pricing is a pricing strategy where businesses set their product or service prices primarily based on the prices established by their competitors. This method involves closely monitoring the pricing structures of rival companies and adjusting one’s own prices accordingly to remain attractive to customers while aiming to maintain profitability. The approach helps businesses stay competitive in the market, especially in industries with significant competition.
Key elements of competition-based pricing include:
Market Analysis: Companies monitor competitors’ pricing and market trends to determine the appropriate price point for their own products.
Price Matching: Some businesses may choose to match or slightly undercut their competitors’ prices to draw in customers.
Differentiation: While prices are influenced by competitors, companies may also consider their own unique selling propositions (USPs) to justify higher or lower prices.
Dynamic Pricing: Prices may change frequently as companies respond to shifts in competitors’ pricing, customer demand, and market conditions.
This pricing strategy is commonly used in industries like retail, hospitality, and electronics, where competitive pressures are significant.
Increased Sales: Competitive pricing can lead to increased sales volumes, especially if a company effectively undercuts competitors or matches their prices, drawing in price-sensitive customers.
Quick Adjustments: Companies can quickly adapt their pricing strategies in response to competitive changes, helping maintain a strong market position.
Reduced Price Wars: By keeping prices competitive without undercutting too aggressively, businesses can avoid damaging price wars that could erode profit margins across the industry.
Cons or Disadvantages
Profit Margin Pressure: Constantly matching or underselling competitors can lead to lower profit margins, impacting overall business profitability.
Limited Differentiation: Focusing too much on competitors’ prices can prevent businesses from emphasizing their unique value propositions, leading to a lack of brand identity.
Reactive Strategy: Competition-based pricing may lead to a reactive rather than proactive pricing strategy, limiting innovation and the potential for creating new pricing models.
Ignoring Costs: Businesses may overlook their own costs when setting prices based solely on competitors, which can result in pricing that doesn’t cover expenses and can lead to financial losses.
While competition-based pricing can provide a strategic advantage in attracting customers, it’s important for businesses to balance this approach with their own cost structures and brand identity to ensure long-term success.
Competition-Based Pricing Examples
Retail Sector Example:
A popular electronics retailer may observe that its main competitor is selling a specific model of smartphone for $699. To attract price-sensitive customers, the retailer decides to price the same smartphone at $689, slightly undercutting the competition while maintaining a sustainable profit margin.
Grocery Store Chains:
Two rival grocery chains often engage in competition-based pricing for staple items such as milk and bread. If one grocery store lowers the price of a gallon of milk to $3.49, the competing store may quickly adjust its price to match or offer a slight discount at $3.47 to draw in customers.
Airline Industry:
Airlines frequently use competition-based pricing, especially for popular routes. If competitor A sells a ticket from New York to Los Angeles for $299, competitor B may set a price of $289 to entice travelers seeking the best deal. Airlines also adjust prices based on demand and competitor offerings, leading to dynamic pricing.
Subscription Services:
Streaming services often adjust their subscription prices based on what competitors are offering. If a new competitor launches with a subscription fee of $9.99 per month, existing services may re-evaluate their pricing structures to ensure they remain competitive, possibly lowering their rates or introducing promotional offers.
Hotel Industry:
In a competitive tourist destination, hotels closely monitor each other’s rates. If Hotel A is offering rooms for $150 a night, Hotel B might lower its price to $145, or promote additional amenities such as free breakfast to encourage bookings without necessarily lowering prices significantly.
These examples illustrate how various industries implement competition-based pricing strategies to attract customers while navigating market dynamics.
Arbitrage Pricing Theory (APT) Advantages and Disadvantages – also explain its Meaning, Importance, Benefits, Assumptions Pros, Limitations, and Cons. Arbitrage Pricing Theory (APT) Essay is a pricing model based on the concept that an asset can produce predictable results. To do this, it is necessary to analyze the relationship between assets and their risk factors as a whole. APT was first developed in 1976 by Stephen Ross to study the influence of macroeconomic factors. In this way, both the return on the portfolio and the return on a particular asset can be predicted by examining the various independent variables in the relationship.
Here is the article to explain, Arbitrage Pricing Theory (APT) and its main points of Meaning, Importance, Benefits, Assumptions, Pros, Advantages, Cons, Limitations, and Disadvantages.
What are the major advantages and disadvantages of APT (arbitrage pricing theory)? It is based on the idea that in a properly functioning securities market there should be no arbitrage available. This makes it possible to predict the outcome of this certainty over a longer period of time. What is meant by Arbitrage Pricing Theory (APT)? The name itself is a suggestion of theory and what it does. This is the mechanism by which investors identify specific assets. Imagine participation at the wrong price. Investors can lower share prices by knowing the value they hold. So, without a doubt, APT can be said to be one of the most important mechanisms that should be used. Why we need to know the underlying advantages, importance, benefits, assumptions, limitations, disadvantages of arbitrage pricing theory (apt) as to give below.
Why is the importance of arbitrage pricing theory?
It is a theory that helps investors and analysts find the right structure and multi-pricing model for asset security based on the relationship that assets have expected returns to risk (watch in youtube). In particular, the theory does its job, which states that a security’s fair market price may not be determined correctly. The main assumption of this theory is that market action is becoming less and less effective and perfect.
Therefore, it can be said that the pricing of acquired assets was not carried out correctly. Or the asset is over-or undervalued, which can cause problems during this period. But here too, market action should ultimately be able to remedy the whole situation or problem where the asset price returns to a fair market condition.
For arbitration, the wrongly valued property securities represent a short-term opportunity for the realization of a practical gain, and this too without any particular risk. When we talk about APT flexibility or arbitrage pricing theory, it can be said that APT flexibility is little more than the stock model or CAPM. In addition, APT is proving to be a very complex alternative to the CAPM option.
It is a theory that provides investors and analysts with the ability to adapt any research that carries out on the market, as well as assets. However, applying this theory is a little more difficult than you can imagine, and also takes a long time. It may take some time to determine the risk factors that could affect the price of the asset in question.
Arbitrage Pricing Theory (APT) explain its Benefits.
Now that you know more about this theory; let’s move on to some of the other important passages that may interest you. Why do you think this model is so popular with investors? Here we will discuss why this model is so important. So you have to read it to the end to understand what we are talking about. Arbitrage pricing theory is an asset pricing theory that measures the expected return on an asset as a linear function of various factors.
The reason APT sees this as a revolutionary idea is that users can easily adapt this model to analyze the best security. There are several other pricing models on the market to help investors decide the value of securities. Nothing works as well as this theory and pricing model. Apart from that, APT is also very useful in building portfolios because with the help of this manager you can easily test the portfolio exposure factors.
What are the assumptions in arbitrage pricing theory?
Arbitrage pricing theory works with a pricing model that takes into account many sources of risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM); which only takes into account one factor for the level of risk in the market as a whole; the APT model takes into account several macroeconomic factors that theoretically determine the risk and return of a particular asset.
These factors provide a risk premium to investors that need attention; because they involve the systemic risk that diversification cannot eliminate. APT offers investors the opportunity to diversify its portfolio; but, also to select individual risk and return profiles based on premiums and sensitivity to macroeconomic risk factors. The venture investor will take advantage of the difference between the expected and actual returns on assets using arbitrage.
To understand APT we need to study the basic assumptions of arbitrage pricingtheory as given below.
This theory is based on the principle of capital market efficiency; and, therefore assumes that all market participants act to maximize profits.
It assumes that there is no arbitrage and when that occurs; participants commit to taking advantage of it and bringing the market back to equilibrium.
The market assumes to be smooth; H. No transaction fees, no taxes, you can short sell, and the number of shares to choose from is unlimited.
Pros of arbitrage pricing theory.
We need to study the main pros or advantages of arbitrage pricingtheory as given below.
The APT model is a multi-factor model. Therefore, the expected return is calculated by taking into account the various factors and their sensitivities that can affect stock price movements. In this way, the factors that have a strong influence on the stock price can be selected.
The APT model is based on assumptions of arbitrary price or market equilibrium which, to some extent, leads to reasonable expectations of returns on risk-weighted assets.
In contrast to CAPM, the basic multi-factor model emphasizes the covariance between return on assets and exogenous factors. CAPM emphasizes the covariance between return on assets and endogenous factors.
The APT model works better in cases with multiple periods than the CAPM, which is only suitable for cases with one period.
The APT model does not require assumptions about the empirical distribution of returns on investment, unlike CAPM, which assumes that returns on equity follow a normal distribution and therefore APT is a less restrictive model.
Cons or Drawbacks or Limitations of Arbitration Pricing Theory.
We need to study the main disadvantages or cons or drawbacks or limitations of arbitrage pricing theory as given below.
The model requires a shortlist of the factors that affect the inventory in question. Finding and listing all the factors can be a difficult task and you run the risk of ignoring several others. There may also be a risk that random correlation could cause a factor to be a supplier to have a significant impact or vice versa.
The expected rate of return for each of these factors must achieve, which depends on the nature of the factor may or may not always be available.
Such a model requires calculating the sensitivity of each factor, which in turn can be a difficult and possibly impracticable task.
The factors that affect the stock price of a particular share can change over time. In addition, the associated sensitivity may fluctuate which must continuously monitor, which makes computation and maintenance extremely difficult.
Advantages of APT (arbitrage pricing theory).
We need to learn the underlying advantages of arbitrage pricingtheory as gives below.
Allow more sources of risk.
APT allows multiple risk factors to include in the data set, rather than excluding them. That way, individual investors can gain more information about why some stock returns move in certain ways. This eliminates many of the movement problems left by other theories because the data set contains more sources of risk.
Allows unexpected changes.
APT is based on the idea that no surprises will happen. These are unrealistic expectations, so Ross adds equations to support the unexpected change. This makes it easier for investors to identify the asset with the greatest potential for growth or default based on the information provided by the opportunity itself.
There are fewer restrictions.
APT does not have the same portfolio requirements as other forecast theories. In addition, there are fewer restrictions on the types of information a prediction can fulfill. Because more information is available with less general limitations, the results with arbitrage pricing theory are more reliable than those of competitors’ models.
No special factors give.
Although APT, like other pricing models, does not offer specific factors, in theory, it takes into account four important factors. APT takes into account changes in inflation, changes in industrial production, changes in the risk premium, and changes in interest rate structure when factoring in long-term forecasts.
Allows investors to find arbitrage opportunities.
APT’s goal is to help investors spot stocks in a market that have been misjudged in some way. Once they can identify, it becomes possible to build a portfolio based on them to produce better returns than the index offers. If the portfolio undervalues, changes in pricing theory can turn opportunities into profits.
Disadvantages of APT (arbitrage pricing theory).
We need to learn the underlying disadvantages of arbitrage pricingtheory as gives below.
Requires that the source of the risk is correct.
Each portfolio exposes to a certain level of risk. To be of use to APTs, investors must have a clear understanding of the risks and sources of these risks. Only then can this theory consider a reasonable estimate of factor sensitivity with greater accuracy? If there is no clear definition of the source of risk, there are more potential outcomes that reduce the effectiveness of the predictive quality provided by APT.
Requires that the portfolio view separately.
APT is only useful when examining one element of risk. Because of this feature, it is almost impossible to examine an entire portfolio with a large number of assets. Therefore, the entire portfolio examines using arbitrage pricing theory. Since not every account but only the portfolio report, certain assumptions must make in the valuation. This can create uncertainties that reduce the accuracy of the analyzed results.
A large amount of data generate.
For a person unexpected with arbitrage pricing theory, the number of statistics to sort via can experience overwhelming. This information generates through a specific analysis of the various factors that cause growth or loss so that prognostic quality can be a factor in portfolio decision making. A person unfamiliar with the purpose of each data point will not understand the results APT produces, making it a useless tool for them.
This is not a guarantee of results.
The arbitrage pricing theory does not guarantee that a profit will be made. Currently, several securities in the market undervalue for reasons beyond APT’s scope. Some risks are not “real” risks because they instill by investors themselves in pricing mechanisms, who have certain fears of certain securities under certain market conditions.
The pros and cons of arbitrage pricing theory aim to look at long-run average returns. Several systematic influences can affect this long-term average. By studying the assets and risks involved, it is possible to predict the expected rate of return. This is a great option for individual securities. However, when examining a portfolio of different securities, APT may not be the right tool.
Arbitrage Pricing Theory (APT) Advantages and Disadvantages; Image by Mohamed Hassan from Pixabay.
Assumptions of CAPM; The Capital Asset Pricing Model (CAPM) measures the risk of security about the portfolio. It considers the required rate of return of security in the light of its contribution to total portfolio risk. CAPM enables us to be much more precise about how trade-offs between risk and return are determined in the financial markets. In CAPM the expected rate of return can also think of as a required rate of return because the market is assumed to be in equilibrium. Even though the CAPM is competent to examine the risk and return of any capital asset such as individual security, an investment project or a portfolio asset, we shall be discussing CAPM concerning risk and return of a security only. So, what is the question; What are the Assumptions of CAPM? Explained.
Here are explain What are the Assumptions of the Capital Asset Pricing Model (CAPM)?
The capital market theory is an extension of the portfolio theory of Markowitz. Also, the portfolio theory explains how rational investors should build efficient portfolio based on their risk-return preferences. Capital Market Asset Pricing Model (CAPM) incorporates a relationship, explaining how assets should be priced in the capital market. As Betas differ according to the market proxy, that they measure against, then in effect, CAPM, has not been and cannot test. We may recall that CAPM states that;
A security with a zero Beta should give a risk-free return. In actual results, these zero beta returns are higher than the risk-free return indicating that there are some non-Beta risk factors or some leftover unsystematic risk. Besides, although, in the long-run, high Beta portfolios have provided larger returns than low-risk ones, in the short-run, CAPM Theory and the empirical evidence diverge strikingly; and, also, sometimes the relationship between risk and return may turn out to be negative which is contrary to CAPM Theory.
It can thus be concluded that CAPM Theory is a neat Theoretical exposition. As well as, The CML and SML are the lines reflecting the total risk and systematic risk elements in the portfolio analysis, respectively. But in the actual world, the CAPM is not in conformity with the real world risk-return trends and empirical results have not always supported the Theory at least in the short-run.
Assumptions of Capital Market Theory:
Investors are expected to make decisions based solely on risk-return assessments.
The purchase and sale transactions can undertake in infinitely divisible units.
Investors can sell short any number of shares without limit.
There is perfect competition and no single investor can influence prices, with no transaction costs, involved.
Personal income tax is assumed to be zero.
Investors can borrow/lend, the desired amount at riskless rates.
Assumptions of CAPM (Capital Asset Pricing Model):
The CAPM base on the following assumptions points.
Risk-averse investors.
Maximizing the utility of terminal wealth.
The choice based on risk and return.
Similar expectations of risk and return.
Identical time horizon.
Free access to all available information.
There is a risk-free asset and there is no restriction on borrowing and lending at the risk-free rate.
There are no taxes and transaction costs, and.
The total availability of assets fixed and assets are marketable and divisible.
The following some key points also very helpful explaining Assumptions of CAPM:
Investors are risk-averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. In other words, the greater the perceived risk of the portfolio; also, the higher return a risk-averse investor expects to compensate for the risk.
Investors make their decisions based on a single period horizon.
Transaction costs are low enough to ignore and assets can be bought and sell in any quantity. As well as, the investor limits only by his wealth and the price of the asset.
Taxes do not affect the choice of buying assets, and.
All individuals assume that they can buy assets at the going market price; and, they all agree on the nature of the return and the risk associated with each investment.
What are the Assumptions of CAPM? Explained. Image credit from ilearnlot.com.
The Capital Asset Pricing Model (CAPM) establishes a linear relationship between the required rate of return of a security and its systematic or un-diversifiable risk or beta. CAPM a model use to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. As well as, CAPM enables us to be much more precise about how trade-offs between risk; and, return determine in the financial markets. So, what is the question; What does mean Capital Asset Pricing Model (CAPM)?
Here are explain What is the Capital Asset Pricing Model (CAPM)? with Meaning and Definition.
In CAPM the expected rate of return can also think of as a required rate of return because the market is assumed to be in equilibrium. Also, the Expected Rate of Return is the return that an investor expects to earn. Required Rate of Return of security the minimum expected the rate of return needed to induce an investor to purchase it.
1] According to A,
“CAPM is a method of determining the fair value of an investment based on the time value of money and the risk incurred.”
2] According to B,
“CAPM is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.”
3] According to C,
“CAPM is used to estimate the fair value of high-risk stock and security portfolios by linking the expected rate of return with risk.”
Capital asset pricing model (CAPM) is a model that establishes a relationship between the required return and the systematic risk of an investment. As well as, It estimates the required return as the sum of the risk-free rate; and, the product of the security’s beta coefficient and equity risk premium. Also, Investors face two kinds of risks: systematic risk and unsystematic risk. As well as, Systematic risk is the risk of the whole economy or financial system [Hindi] going down and causing low or negative returns.
For example;
The risk of recession, enactment of unfavorable regulation, etc. Systematic risk can’t avoid adding more investments to the portfolio (i.e. diversification) because a downturn in the whole economy affects all investments.
Unsystematic risk, on the other hand, is the risk specific to a particular investment. For example, unfavorable court ruling affecting the company, major disruption in the company’s supply chain, etc. Such risks can mitigate by adding additional investments to a portfolio. For example, a portfolio of 100-stocks is less prone to the negative performance of one company due to any specific event affecting it.
CAPM calculate according to the following formula:
Rrf + [Ba x (Rm – Rrf) ] = Ra
Where in:
Ra = Expected return on a security.
Rrf = Risk-free rate.
Ba = Beta of the security, and.
Rm = Expected return on the market.
Since unsystematic risk can eliminate through diversification; Also, the capital asset pricing model doesn’t provide any reward for taking such a risk. It measures the required return based on the level of systematic risk inherent in a particular investment.
What does mean Capital Asset Pricing Model (CAPM)? Image credit from ilearnlot.com.
Meaning of Arbitrage Pricing Theory (APT) is one of the tools used by investors and portfolio managers who explain the return of severity based on their respective beta. This theory was developed by Stephen Ross. In finance, the APT is a general theory of property pricing that believes that the expected return of financial assets can model as a linear function of various factors or theoretical market index, wherein each of the factors The sensitivity of change is represented by a factor-specific beta coefficient. So, what is the question; What is Arbitrage Pricing Theory (APT)? Meaning and Definition.
Here are explains What is Arbitrage Pricing Theory (APT)? with Meaning and Definition.
APT is a multi-factor property pricing model based on the idea that calculating asset returns can be done using linear relationships between the expected return of assets and many macroeconomic variables that hold systematic risk. Also, This theory was created in 1976 by economist Stephen Ross. The arbitrage pricing principle provides a multi-factor pricing model for securities based on the relation between the expected return of financial assets and their risk to analysts and investors. This is a useful tool to analyze the portfolio from a price investment perspective, to temporarily identify the securities incorrectly.
APT is a more flexible and complicated option for the Capital Asset Pricing Model (CAPM). The theory provides investors and analysts with the opportunity to customize their research. As well, the model-derived rate of return will use to correctly assess the property; Also, the asset value should be equal to the expected end of the discount period at the rate mentioned by the model. If the price goes away, then arbitrage will bring it back to the line.
Women Get Shopping; What is Arbitrage Pricing Theory (APT)? Meaning and Definition. Image credit from ilearnlot.com.
What does mean the Arbitrage Pricing Theory (APT)?
Arbitrage Pricing Theory (APT) is an extension of CAPM. The pricing model given by APT is the same as CAPM. It is a model under equilibrium. The difference is that APT is based on a multi-factor model. Also, the Arbitrage pricing theory holds that arbitrage behavior is a decisive factor in the formation of modern efficient markets (that is, market equilibrium prices).
If the market does not reach equilibrium, there will be risk-free arbitrage opportunities in the market. And multiple factors uses to explain the return of risk assets, and according to the principle of no-arbitrage; there is an (approximate) linear relationship between the balanced return of risk assets and multiple factors. Also, The previous CAPM model predicts that there is a linear relationship between the returns of all securities; and, the return of a unique public factor (market portfolio).
Significance of Arbitrage Pricing Theory (APT):
Arbitrage pricing theory derives a market relationship similar to the capital asset pricing model. The arbitrage pricing theory base on the multi-factor model of the rate of the return formation process. Also, It believes that the rate of return of securities linearly relates to a set of factors; which represent some basic factors of the rate of return of securities.
When the rate of return form by a single factor (market combination), you will find that the arbitrage pricing theory forms a relationship with the capital asset pricing model. Therefore, the arbitrage pricing theory can consider as a generalized capital asset pricing model, providing investors with an alternative method to understand the equilibrium relationship between risk and return in the market. Also, Arbitrage pricing theory and modern asset portfolio theory, capital asset pricing model, option pricing model, etc. constitute the theoretical basis of modern finance.
Difference between APT and CAPM:
In 1976, American scholar Stephen Rose published the classic paper “Arbitrage Theory of Capital Asset Pricing” in the Journal of Economic Theory; and, proposed a new asset pricing model, which is the arbitrage pricing theory (APT theory). Also, Arbitrage pricing theory uses the concept of arbitrage to define equilibrium, does not require the existence of market portfolios, and requires fewer assumptions than the capital asset pricing model (CAPM model), and more reasonable.
Like the capital asset pricing model, the arbitrage pricing theory assumes:
Investors have the same investment philosophy;
The investor is unsatisfied and wants to maximize utility;
Also, The market is complete.
Unlike the capital asset pricing model, arbitrage pricing theory does not have the following assumptions:
Single investment period;
There is no tax;
Also, Investors can borrow freely at a risk-free rate;
Investors choose investment portfolios based on the mean and variance of returns.
The relationship between the arbitrage pricing theory and capital asset pricing model:
Both assume that there are no transaction costs or transaction taxes in the capital market; or both believe that if there are transaction costs or transaction taxes, they are the same for all investors.
Both of them divide the existing risks into systemic and non-systemic risks, that is, market risk and the company’s own risk. Moreover, both models believe that through the diversified portfolio of investments and the rational optimization of the investment structure by investors; the company ’s risks can be largely or even eliminated. Therefore, when calculating the expected return of the investment portfolio; the mathematical expressions of both models believe that the capital market will not compensate investors; because, they have assumed this part of the risk, so they not include in the calculation.
Capital asset pricing theory can regard as a special case of arbitrage pricing theory under stricter assumptions.
The role of the arbitrage pricing theory and capital asset pricing model:
The proposal of CAPM and APT has had a huge impact on financial theory research and practice all over the world. Its main performances are:
Most institutional investors evaluate their investment performance according to the relationship between expected return and β coefficient (or unit risk-reward);
The regulatory authorities of most countries take the relationship between the expected rate of return; and, the β coefficient together with the prediction of the market index rate of return as an important factor when determining the capital cost of the regulated object;
The court often uses the relationship between the expected rate of return and β coefficient to determine the discount rate when measuring the amount of compensation for future loss of income
Many companies also use the relationship between the expected rate of return and the β coefficient to determine the minimum required rate of return when making capital budget decisions. As well as it can see that the combination of the two can make more accurate predictions than pure APT; and, can make more extensive analysis than CAPM, to provide more adequate guidance for investment decisions.
