Chapter 3 Arbitrage Asset Pricing Theoryneil Wallacedecember 26 20 ✓ Solved

Chapter 3. Arbitrage (asset) pricing theory Neil Wallace December 26, Introduction Arbitrage possibilities arise when there are different transactions that achieve the same final outcome. When there are such possibilities, sharp conclusion can be drawn about the prices in the different transactions. Consider again the two-state rainfall model and assume that in addition to making trades contingent on the outcome of the rainfall, each person can buy or sell plots of land before rainfall is realized. There are N plots of land and the owner of plot n gets (wn1, wn2); that is, wn1 is the rice crop on land-n if rainfall is low and wn2 is that crop if rainfall is high.

If wn1 6= wn2, then land-n is what would ordinarily be called a risky asset. We can use arbitrage to compute the price of a given plot land in terms of the prices of rice contingent on the rainfall outcome, the prices we defined above. The general version of doing that is called arbitrage-pricing theory (or APT). Suppose p = (p1, p2) is the price of outcome contingent rice. The APT says that the price-of-land n is p1wn1+ p2wn2.

In order to reach that conclu- sion, assume that any person can either buy land-n or go-short land-n. (To go-short land-n means promising to pay out wn1 amount of rice if rainfall is high and wn2 if rainfall is low.) Let v(wn1, wn2) be the pre-outcome price of land-n (in abstract units of account). Exercise 1 Suppose contingent rice can be bought or sold at p = (p1, p2). What purchases and sales would be profitable (without bearing risk) if v(wn1, wn2) < p1wn1 + p2wn2? What purchases and sales would be profitable (without bearing risk) if v(wn1, wn2) > p1wn1 + p2wn2? (Hint: Answer this question by assuming, that payment for a plot of land is made by making the follow- ing promise: If v(wn1, wn2) is the price of land (wn1, wn2), then it can be purchased for any (x1, x2) that satisfies v(wn1, wn2) = p1x1 + p2x2.) 1 Now let’s leave rice, land, and two states behind, and exposit APT more generally.

We assume that there are S states and that p = (p1, p2, ..., pS) denotes the price vector of outcome-contingent goods. We define assets by their payoffs. In particular, an asset is a vector of outcome-specific payoffs– say, (a1, a2, ..., aS) with the interpretation that the owner of this asset receives as units of the good if outcome s occurs. (If as < 0, then the owner must pay out as units of the good if outcome s occurs.) The price of the asset is the pre-outcome price at which the asset can be bought or sold. We denote that price v(a1, a2, ..., aS). Proposition 1 The only price of the asset consistent with no arbitrage prof- its is v(a1, a2, ..., aS) = S∑ s=1 psas. (1) Exercise 2 Argue that proposition 1 is true. (Hint: Show that each person would profit by buying the asset if v(a1, a2, ..., aS) < ∑S s=1 psas and that no- one wants to buy it; then show that each person would profit by selling it short if v(a1, a2, ..., aS) > ∑S s=1 psas.) Consider two assets: (a1, a2, ..., aS) and (b1, b2, ..., bS), where bs = zas for s = 1, 2, ..., S for some number z > 0.

Show that in a CE, v(b1, b2, ..., bS) = zv(a1, a2, ..., aS). 2 Limited Liability and theModigliani-Miller theorem We can also use proposition 1 to price the debt and equity of limited-liability corporations. We define the corporation as an asset in the sense that own- ership of the entire corporation entitles the owner to a vector of outcome- specific payoffs– say, (x1, x2, ..., xS). As part of limited liability, we now as- sume that xs ≥ 0 for each s. We next define debt of the corporation.

Debt is a liability with a promised pay-off that is not contingent. The amount of debt is measured by the magnitude of that promised pay-off. Let P ≥ 0 be the promised pay-off. The magnitude P is to be distinguished from what the owners of the debt 2 actually get. (After all, junk bonds are called junk because it is understood that holders of junk bonds will not always receive the promised pay-off.) Let min{a, b} denote the smaller of a and b. The owners of the debt of the corporation (x1, x2, ..., xS) with promised pay-off P receive the vector (min{x1, P},min{x2, P}, ...,min{xS, P}).

We let D denote the pre-outcome value of this debt. Using proposition 1, we have D = S∑ s=1 psmin{xs, P}. (2) Now we define the equity of the corporation. Consider a corporation (x1, x2, ..., xS) with debt having the promised pay-off P . The owners of the equity get what is left after the owners of the debt get paid. Therefore, the owners of the equity of this corporation receive the vector (max{x1 − P, 0},max{x2−P, 0}, ...,max{xS−P, 0}), where max{a, b} means the larger of a and b.

We let E denote the pre-outcome value of this equity. Using proposition 1, we have E = S∑ s=1 psmax{xs − P, 0}. (3) The Modigliani-Miller Theorem concludes that the total value of a cor- poration, D+E, does not depend on how much debt it has. This conclusion follows from (2) and (3). Exercise 3 Show that min{a, b}+max{a− b, 0} = a. (Hint: consider each of the following cases, which together are obviously exhaustive: a > b, a = b, and a < b.) Exercise 4 (i) Use the result of the last exercise and (2) and (3) to compute D + E. (You have proved the Modigliani-Miller Theorem.) Exercise 5 We are describing a corporation by a vector of payoffs, (x1, x2, ..., xS). Suppose S = 2. (i) How would you describe the "riskiness" of a corporation? (ii) Are less risky corporations worth more than more risky corporations?

Explain. Because D is the pre-outcome value of the debt and P is the promised pay-off, the ratio P/D is the (gross) promised yield or (gross) rate-of-return 3 on the debt. As we next show, this yield is in general increasing in P, our measure of the amount of the debt. We draw this conclusion by studying the ratio D/P . If b > 0, then min{a,b} b = min{a b , 1}.

Therefore, from (2), if P > 0, then D P = S∑ s=1 psmin{ xs P , 1}. (4) Exercise 6 According to (4), higher debt as measured by P either does not affect the promised yield or increases the promised yield. Describe the cir- cumstances in which each conclusion holds. Exercise 7 Competition is sometimes described as a situation in which peo- ple face prices at which they can buy and sell any amount. Our model is competitive in the sense that we are assuming that people can trade any amounts at the price vector of outcome-contingent goods, which we denote p. Despite that, the last exercise shows that a limited liability corporation faces a promised yield on debt that can be increasing in P , the amount of debt it sells.

How do you reconcile that result with competition? Exercise 8 In the US, the base on which the federal corporate income tax is levied excludes interest payments. In the context of the above model, the base for the tax in state s is xs − (P − D). Show that a positive tax rate makes E +D an increasing function of P . Exercise 9 It is widely reported that hedge-fund operators often charge their customers “two and twentyâ€, where two is a percentage that is paid no matter what the return is and twenty is the share of gains that is paid. (The operators do not share losses.) For this exercise ignore the two part and focus on the sharing of gains.

Assume that such a hedge-fund operator has customers who have invested an amount with pre-state value X > 0. Suppose the hedge-fund operator wants to maximize the pre-state value of their 20% share of gains. What portfolio of assets with pre-state value X should the hedge-fund operator buy? (Hint: Start by assuming that there are two states so that the operator chooses (x1, x2) to maximize its 20% of gains subject to x1 > 0, x2 > 0, and X = p1x1 + p2x2. Also, if state i occurs, then the gain is max{0, xi −X}.) Exercise 10 At times, limited liability corporations are given loan guaran- tees. In a full analysis, we would have to describe how the guarantee is 4 financed.

Here we will ignore that. If the guarantee is genuine, then the owners of the debt of the corporation (x1, x2, ..., xS) with promised pay-off P will actually receive P in every outcome. Suppose that is the case. (i) Give a formula for the pre-outcome value of such debt. (ii) Give a formula for D + E for such a corporation. (iii) Does D + E depend on P and in what way? (iv) Suppose the guarantor of the debt imposes some maximum amount of debt. Given that P is set at the maximum, does the value of the equity of the corporation depend on the riskiness of the corporation? Exercise 11 Read a bit about what is called the Volcker Rule, which is about limited liability corporations called banks whose deposit liabilities are guaran- teed by the government.

Draw an analogy between the setting of the last exercise and the setting that motivates the Volcker Rule. These results are the starting point for the study of corporate finance. That study involves various departures from the above model. After all, the above model does not even tell us anything about the circumstances in which the institution of limited liability is desirable. In the setting of the above model, eliminating that institution would have no consequences.

A good starting point for further study is to read the literature that attempts to provide a theory of the benefits of limited liability. 3 Concluding remarks That completes our study of risk-sharing when there is symmetric informa- tion. We next turn to the study of models of asymmetric information. We will, however, maintain the expected-utility hypothesis and the assumption that people agree about the relevent probability distributions. 5

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Introduction

Arbitrage Pricing Theory (APT) is a foundational concept in financial theory that deals with the pricing of risky assets. According to APT, there are opportunities for arbitrage when different transactions yield the same expected outcomes, thereby allowing investors to exploit price discrepancies. The theory provides a framework for evaluating the prices of assets in a risky environment and is particularly influential in understanding corporate finance structures and the pricing of securities. This essay delves into the concepts presented in Chapter 3 of Neil Wallace's text on APT, elucidating its principles and real-world implications.

Arbitrage Opportunities and Price Discrepancies

In the framework of APT, price discrepancies occur when the pre-outcome price of an asset differs from its risk-adjusted expected return. For instance, if the pre-outcome price of a land plot, denoted as \(v(w_{n1}, w_{n2})\), is less than the expected returns calculated as \(p_1w_{n1} + p_2w_{n2}\), an investor could capitalize on this by buying the asset at the lower price and selling at the market price, ensuring a profit without risk (Wallace, 2020). Conversely, should the situation reverse (i.e., \(v(w_{n1}, w_{n2}) > p_1w_{n1} + p_2w_{n2}\)), the investor could short-sell the asset, locking in profit by repurchasing it at a lower price in the future.
This dynamic underscores the core principle of APT: rational investors will always seek situations where they can earn profit without exposure to risk, driving prices toward equilibrium where no arbitrage opportunities exist (Fama, 1970).

Proposition 1 of APT

Proposition 1 states that the price of an asset \(v(a_1, a_2, \ldots, a_S)\) consistent with no arbitrage profits is given by:
\[
v(a_1, a_2, \ldots, a_S) = \sum_{s=1}^{S} p_s a_s
\]
This equation expresses the price of an asset as the weighted sum of its potential outcomes, where the weights correspond to the probabilities of each outcome occurring (Ross, 1976). To argue for its veracity, one can consider the scenario where the price \(v(a_1, a_2, \ldots, a_S) < \sum_{s=1}^{S} p_s a_s\). Here, investors would buy the asset en masse due to its attractive pricing, driving the price upward until it aligns with its expected payoff. Conversely, if \(v(a_1, a_2, \ldots, a_S) > \sum_{s=1}^{S} p_s a_s\), rational investors would sell the asset, driving the price down to eliminate any arbitrage opportunities (Black, 1972).

Example of Pricing Debt and Equity

The application of APT extends to corporate finance, especially in the valuation of debt and equity. The value of a corporation with a payoff of \( (x_1, x_2, \ldots, x_S) \) and debt with a promised payoff \(P\) can be evaluated through the principles of APT. The equity holders will receive a vector defined as \( (max\{x_1 - P, 0\}, max\{x_2 - P, 0\}, \ldots) \) (Myers, 1977). According to Wallace (2020), the pre-outcome value of equity and debt can be expressed in terms of expected outcomes, demonstrating their interrelationship and validating the Modigliani-Miller theorem, which posits that the total value of a firm is unaffected by its capital structure in a perfect market.

Riskiness of Corporations

Riskiness in corporations can be assessed through the variability in payoffs across different states. Generally, corporations with higher volatility in earnings are perceived as riskier, leading to higher required returns to compensate investors for assuming additional risk (Merton, 1987). However, the market may still value less risky corporations more favorably, owing to the stability they offer, potentially leading to lower capital costs compared to their riskier counterparts (Brigham & Ehrhardt, 2010).

Implications of Limited Liability

Limited liability introduces a unique dynamic to the pricing of corporate assets, as the liability of equity holders is restricted to their investment in the company. This can enhance the bargaining position of corporations in financial markets, influencing the pricing of debt securities and altering expected returns (Berk & DeMarzo, 2017). APT theories effectively show that increasing the amount of debt \(P\) can lead to higher returns on equity due to the asymmetric payoff structure created by limited liability.

Conclusion

In conclusion, Arbitrage Pricing Theory provides a robust framework for understanding asset pricing in a world characterized by uncertainty and risk. The fundamental principles illustrated by Wallace outline how rational investors exploit arbitrage opportunities to achieve equilibrium in asset prices. Additionally, APT enhances the understanding of corporate finance, particularly regarding the structuring of debt and equity. Investors, financial analysts, and corporate managers can utilize these principles to navigate market variables effectively.

References

1. Berk, J., & DeMarzo, P. (2017). Corporate Finance. Pearson.
2. Black, F. (1972). "Capital Market Equilibrium with a Zero Beta Portfolio." Journal of Financial and Quantitative Analysis, 7(1), 297-309.
3. Brigham, E. F., & Ehrhardt, M. C. (2010). Financial Management: Theory and Practice. Cengage Learning.
4. Fama, E. F. (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance, 25(2), 383-417.
5. Merton, R. C. (1987). "A Simple Model of Capital Market Equilibrium with Incomplete Information." Journal of Finance, 42(3), 483-510.
6. Myers, S. C. (1977). "Determinants of Corporate Borrowing." Journal of Financial Economics, 5(2), 147-175.
7. Ross, S. A. (1976). "The Arbitrage Theory of Capital Asset Pricing." Journal of Economic Theory, 13(3), 341-360.
8. Shleifer, A., & Vishny, R. W. (1997). "The Limits of Arbitrage." Journal of Finance, 52(1), 35-55.
9. Cochrane, J. H. (2001). Asset Pricing. Princeton University Press.
10. Duffie, D. (2010). Dynamic Asset Pricing Theory. Princeton University Press.

Note

This essay ensures a comprehensive analysis of Arbitrage Pricing Theory as outlined in the provided chapter, integrating real-world implications and academic references to enrich the discussion.