- Date: 24 Nov. (Thu.)
- Place: W.W. 6th-floor, Colloquium Room and on the Web (Zoom)
- Time: 16:30-18:00
- Speaker: Michael Zierhut (KIER, Kyoto University)
- Title: The Arbitrage Pricing Theory in Incomplete Markets
- Abstract:
The arbitrage pricing theory (APT) is traditionally viewed as a descriptive theory: If asset prices are decomposed into systematic and idiosyncratic components, the latter are negligible for almost all assets in large markets. This paper analyzes its role as a predictive theory: When prices of systematic risk factors are estimated by means of linear regression, these estimates are a lower-dimensional representation of a pricing kernel. Such estimates can be used to predict arbitrage-free prices for new assets. Market structure matters: When markets are complete, there is a unique pricing kernel and factor pricing is always arbitrage-free. When markets are incomplete, this method may select a nonpositive pricing kernel. This leads to a problem that is robust in a topological sense: For an open set of arbitrage-free markets, estimated factor models do not assign arbitrage-free prices out of sample. The critical assumption is therefore not that markets grow large, but that markets grow complete.
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