THE ARBITRAGE PRICING THEORY: ESTIMATION AND APPLICATIONS

This thesis deals with two different, although closely related problems. The first part, including chapters 2 and 3 deals with the problem of estimation of the multifactor structure of security returns and tests of the Arbitrage Pricing Theory (APT). Although widely recognized as a theoretically strong and very general theory of asset prices, a frequent critique to the APT is its ambiguity in not naming the factors sources of risk. These have to be estimated from observation of the joint behavior of security returns. Actually this is a rather formidable task with a number of limitations (mainly computational) making it even harder. Some shortcomings present in the generally used procedures of estimation are reviewed in chaper 2 with the aid of a simulated universe of assets. A simple estimation procedure is developed and shown to be, analytically as well as numerically with simulated data, more efficient than previous estimation procedures. Using the new procedure the multifactor structure of the return generating process in the US stock market is estimated. Asset prices are found to be priced so as to yield a linear relationship between expected return and risk, as predicted by the APT. The second part, including chapters 4 and 5, deals with the problem of testing whether, in the international capital market, the pricing of assets takes place simultaneously as in a single and integrated market, or rather separately in each market because of barriers to international diversification. The test is equivalent to testing for the presence of arbitrage opportunities across borders. When tested empirically in US and Canadian stock markets, two pieces of evidence are found supporting the view of both markets as parts of a single integrated North American stock market. First, evidence is found that the international risky factors are equally priced in both countries. Secondly, an (anomalous) nonrisky factor related to firm size is found also equally priced in both markets