Scientific Portfolio AI- Generated Summary

“The Arbitrage Theory of Capital Asset Pricing” is a paper written by Stephen A. Ross that examines the arbitrage model of capital asset pricing and proposes it as an alternative to the mean variance model. The mean variance model, introduced by Sharpe, Lintner, and Treynor, is a major analytic tool for explaining phenomena observed in capital markets for risky assets. However, the linear relation in the mean variance model is difficult to justify on theoretical and empirical grounds.

The arbitrage model, on the other hand, is based on the principle of no-arbitrage and does not rely on assumptions of normality in returns or quadratic preferences. The paper rigorously examines the arbitrage model and shows that it can explain the same phenomena as the mean variance model.

The paper begins by introducing the mean variance model and its principal relation, which holds that for any asset, its expected return is equal to the riskless rate of interest plus the expected excess return on the market multiplied by the beta coefficient on the market. The paper then discusses the difficulties in justifying the assumptions of normality in returns and quadratic preferences that underlie the mean variance model.

The paper then introduces the arbitrage model, which is based on the principle of no-arbitrage. The arbitrage model assumes that there are no arbitrage opportunities in the market, which means that it is not possible to make a riskless profit by buying and selling assets. The paper shows that the arbitrage model can explain the same phenomena as the mean variance model, but without relying on the assumptions of normality in returns and quadratic preferences.

The paper concludes by discussing the implications of the arbitrage model for empirical research. The paper suggests that the arbitrage model can be used to test the efficiency of capital markets and to identify mispricing’s in asset prices. The paper also suggests that the arbitrage model can be used to develop trading strategies that exploit mispricing’s in asset prices.