Report

Measuring the pricing error of the arbitrage pricing theory

Abstract: This paper provides an exact Bayesian framework for analyzing the arbitrage pricing theory (APT). Based on the Gibbs sampler, we show how to obtain the exact posterior distributions for functions of interest in the factor model. In particular, we propose a measure of the APT pricing deviations and obtain its exact posterior distribution. Using monthly portfolio returns grouped by industry and market capitalization, we find that there is little improvement in reducing the pricing errors by including more factors beyond the first one.

Keywords: Arbitrage; Prices;

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 1995

Number: 189