Technical Analysis

Technical analysis is a method of evaluating securities that involves a statistical analysis of

market activity, such as price and volume. Technical analysis is a trading discipline employed to
evaluate investments and identify trading opportunities by analyzing statistical trends gathered from
trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to
evaluate a security's intrinsic value, technical analysts focus on patterns of price movements, trading
signals and various other analytical charting tools to evaluate a security's strength or weakness.
A technical analyst, or technician, is a securities researcher who analyzes investments based
on past market prices and technical indicators. Technicians believe that short-term price movements are
the result of supply and demand forces in the market for a given security. Thus, for technicians,
the fundamentals of the security are less relevant than the current balance of buyers and sellers. Based on
the careful interpretation of past trading patterns, technical analysts try to discern this balance with the
aim of predicting future price movements.

Assumptions of Technical analysis

Technical analysis is based on three assumptions:
1. The market discounts everything.
2. Price moves in trends.
3. History tends to repeat itself.

1. The Market Discounts Everything-

Many experts criticize technical analysis because it only considers
price movements and ignores fundamental factors. The counterargument is based on the Efficient Market
Hypothesis, which states that a stock’s price already reflects everything that has or could affect a
company – including fundamental factors. Technical analysts believe that everything from a company’s
fundamentals to broad market factors to market psychology is already priced into the stock.

2. Price Moves in Trends-

Technical analysts believe that prices move in short-, medium-, and long-term
trend. In other words, a stock price is more likely to continue a past trend than move erratically. Most
technical trading strategies are based on this assumption.

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3. History Tends to Repeat Itself-
Technical analysts believe that history tends to repeat itself. The
repetitive nature of price movements is often attributed to market psychology, which tends to be very
predictable based on emotions like fear or excitement. Technical analysis uses chart patterns to analyze
these emotions and subsequent market movements to understand trends. While many form of technical
analysis have been used for more than 100 years, they are still believed to be relevant because they
illustrate patterns in price movements that often repeat themselves.

DOW Theory-

The Dow theory is a theory which says the market is in an upward trend if one of its averages
(industrial or transportation) advances above a previous important high and is accompanied or followed
by a similar advance in the other average. For example, if the Dow Jones Industrial Average (DJIA)
climbs to an intermediate high, the Dow Jones Transportation Average (DJTA) is expected to follow suit
within a reasonable period of time. Dow believed that the stock market as a whole was a reliable measure
of overall business conditions within the economy and that by analyzing the overall market, one could
accurately gauge those conditions and identify the direction of major market trends and the likely
direction of individual stocks. 
Dow first used his theory to create the Dow Jones Industrial Index and the Dow
Jones Rail Index (now Transportation Index), which were originally compiled by Dow for The Wall
Street Journal. Dow created these indexes because he felt they were an accurate reflection of the business
conditions within the economy because they covered two major economic segments: industrial and rail
(transportation). While these indexes have changed over the last 100 years, the theory still applies to
current market indexes. 

There are six main components to the Dow Theory. They are summarized briefly here:

1. The market discounts everything. The Dow Theory operates on the efficient markets

hypothesis (EMH), which states that asset prices incorporate all available information. In other words,
this approach is the antithesis of behavioral economics. Earnings potential, competitive advantage,
management competence — all of these factors and more are priced into the market, even if not every
individual knows all or any of these details. In more strict readings of this theory, even future events are
discounted in the form of risk.
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2. There are three kinds of market trends. Markets experience primary trends which last a year or
more, such as a bull or bear market. Within these broader trends, they experience secondary trends, often
working against the primary trend, such as a pullback within a bull market or a rally within a bear market;
these secondary trends last from three weeks to three months. Finally, there are minor trends lasting less
than three weeks, which are largely noise.
3. Primary trends have three phases. A primary trend will pass through three phases, according to the
Dow theory. In a bull market, these are the accumulation phase, the public participation (or big move)
phase and the excess phase. In a bear market, they are called the distribution phase, the public
participation phase and the panic (or despair) phase. 
4. Indices must confirm each other. In order for a trend to be established, Dow postulated, indices or
market averages must confirm each other. If asset prices were rising but the railroads were suffering, the
trend would likely not be sustainable. The converse also applies: if railroads are profiting but the market
is in a downturn, there is no clear trend.
5. Volume must confirm the trend. Volume should increase if price is moving in the direction of the
primary trend, and decrease if it is moving against it. Low volume signals a weakness in the trend. For
example, in a bull market, volume should increase as the price is rising, and fall during secondary
pullbacks. If, in this example, volume picks up during a pullback, it could be a sign that the trend is
reversing as more market participants turn bearish.
6. Trends persist until a clear reversal occurs. Reversals in primary trends can be confused with
secondary trends. It is difficult to determine whether an upswing in a bear market is a reversal or a short-
lived rally to be followed by still lower lows, and the Dow Theory advocates caution, insisting that a
possible reversal be confirmed.
Now that we understand how Dow Theory defines a trend, we can look at the finer points of trend
analysis.
Dow theory identifies three trends within the market: primary, secondary and minor. Let us now take a
look at each trend.

1. Primary Trend
In Dow Theory, the primary trend is the major trend of the market, which makes it
the most important one to determine. This is because the overriding trend is the one that affects the
movements in stock prices. The primary trend will also impact the secondary and minor trends within the
market.

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 The security price trend may be either increasing or decreasing. When the market exhibits an
increasing trend, it is referred to a bull market. The bull market shows three clear-cut-peaks. Each peak is
higher than the previous one. The bottoms are also higher than the previous bottoms. The reactions
following the peak usually half before the previous bottoms. The phases leading to the
three peaks of revival, improvement in corporate profits and speculation. The rival period encourages
more investors to buy scrip as their as their expectation about the future is high. In the second phase
increase corporate profits result in a further price rise. In the third phase, prices advance due to inflation
and speculation.
The reverse is true with the bear market. Here the first phase of fall starts with the abandonment
of hope. The changes in the prices moving back to the previous high level appear to below. This results in
the sale of shares. In the second phase companies report lower profit and dividends. This
leads to selling pressure. The final phase is characterized by the distress sale of shares. During the bear
phase in Bombay Stock exchange, more than two-thirds of stocks were inactive.

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2. Secondary, or Intermediate, Trend
In Dow Theory, a primary trend is the main direction in
which the market is moving. Conversely, a secondary trend moves in the opposite direction of the
primary trend, or as a correction to the primary trend.
The secondary or intermediate trend moves against the main trend and leads to correction. In a bull
market the Secondary trend the result in the fall of about 33-66 per cent of the earlier rise. In a bear
market, the secondary trend carries the price upwards and corrects the main tend. The correction would
be 33-66 per cent of the earlier fall. The intermediate trends correct the overbought and oversold
positions. It provides breathing space to the market. Compared to the time taken for the primary trend,
secondary trend is swift and quicker.

3. Minor Trend
The last of the three trend types in Dow Theory is the minor trend, which is defined as
a market movement lasting less than three weeks. The minor trend is generally the corrective moves
within a secondary move, or those moves that go against the direction of the secondary trend.
Due to its short-term nature and the longer-term focus of Dow theory, the minor trend is not of major
concern to Dow theory followers. But this doesn't mean it is completely irrelevant; the minor trend is
watched with the large picture in mind, as these short-term price movements are a part of both the
primary and secondary trends.
Most proponents of Dow theory focus their attention on the primary and secondary
trends, as minor trends tend to include a considerable amount of noise. If too much focus is placed on

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minor trends, it can to lead to irrational trading, as traders get distracted by short-term volatility and lose
sight of the bigger picture.
Support and Resistance Level-
Support and Resistance levels are an integral part of technical
analysis. A support level exists at a price where considerable demand for that stock is expected to prevent
a further fall in the price level. The fall in the price may be halted for the time being, or it may even result
in a price reversal. In the support level demand for the scrip is expected to remain.
In the resistance level, the supply of scrip is greater than the demand and the further rise in
price in prevented. The selling pressure is greater, and the increase in price is halted for the time being.
Support and resistance usually occur whenever turnover of a large number of shares tends to be
concentrated at several price levels. When the stock touches a certain level and then drops, this is called
resistance, and if the stock goes down to a certain level and then rises, there exists a support.

If the scrip price reverse the support level and moves downward, it means that the selling pressure has
overcome the potential buying pressure, signaling the possibility of a further fall in the value of the scrip.
It indicates the violation of the support level and a bearish market.
If the scrip penetrates the previous top and moves above, it is a violation of the resistance level. At this
point, the buying pressure would be more than the selling pressure. If the scrip moves above the double
top or triple top formation, it indicates a bullish market. The support and resistance levels need not be
formed only on tops or bottoms. They can be on the trend lines or gaps of the chart.
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 Chart-
A chart is a graphical representation of data, in which "the data is represented by symbols, such
as bars in a bar chart or lines in a line chart. A chart can represent tabular numeric data, functions or some
kinds of qualitative structure and provides different info. Charts are often used to ease understanding of
large quantities of data and the relationships between parts of the data. Charts can usually be read more
quickly than the raw data.

Types of Chart-

There are four primary types of charts used by investors and traders depending on the
type of information they’re seeking and their desired goals. These chart types include line charts, bar
charts, candlestick charts, and point and figure charts. 

1. Line Charts-
Line charts are the most basic type of chart because it represents only the closing prices
over a set period. The line is formed by connecting the closing prices for each period over the timeframe.
While this type of chart doesn’t provide much insight into intraday price movements, many investors
consider the closing price to be more important than the open, high, or low price within a given period.
These charts also make it easier to spot trends since there’s less ‘noise’ happening compared to other
chart types.

2. Bar Charts-

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 Bar charts expand upon the line chart by adding the open, high, low, and close – or the
daily price range, in other words – to the mix. The chart is made up of a series of vertical lines that
represent the price range for a given period with a horizontal dash on each side that represents the open
and closing prices. The opening price is the horizontal dash on the left side of the horizontal line and the
closing price is located on the right side of the line. If the opening price is lower than the closing price,
the line is often shaded black to represent a rising period. The opposite is true for a falling period, which
is represented by a red shade.

3. Candlestick Charts
Candlestick charts originated in Japan over 300 years ago, but have since
become extremely popular among traders and investors. Like a bar chart, candlestick charts have a thin
vertical line showing the price range for a given period that’s shaded different colors based on whether
the stock ended higher or lower. The difference is a wider bar or rectangle that represents the difference
between the opening and closing prices.

Falling periods will typically have a red or black candlestick body, while rising periods will have a white
or clear candlestick body. Days where the open and closing prices are the same will not have any wide
body or rectangle at all.

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4. Point and Figure Charts-
Point and figure charts are not very well known or used by the average
investor, but they have a long history of use dating back to the first technical traders. The chart reflects
price movements without time or volume concerns, which helps remove noise – or insignificant price
movements – that can distort a trader’s view of the overall trend. These charts also try to eliminate
the skewing effect that time has on chart analysis.

Trend Lines-

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They are lines drawn along the market trends to analyze the trends and trend changes. They  are formed
by joining two or more support pivot points or resistance pivot points. This when extended offers support
and resistance levels into the future.

These are the basic technical analysis tools. A line which slopes upwards indicates an up trend and
provides support level to advancing price and a line which slopes downwards indicates a down trend and
provides resistance level to declining price.
How to Trend Lines Constructed

To draw a straight line we need at least two points. So a line is drawn by connecting two major swing
highs or two major swing lows. If this line offers resistance or support to the next swing high or next
swing low, then this line becomes a valid trend line.

So a trend line will have three points.

1. Initiating Point: First point from where the line starts.
2. Confirming Point: Second point which confirms the straight line.
3. Validating Point: Third point which confirms the validity of the trend line.

An up trend is characterized by higher high swing tops and higher high swing bottoms. The lowest points
of two consecutive swing bottoms are joined by a straight line and extended towards right. This will have
a slope upwards. So this line is termed as rising trend line. It visually represents the up trend and offers
support to the future swing bottoms. If the next swing bottom takes support on the straight line, then this
line becomes a valid up trend line. A down trend is characterized by lower low swing bottoms and lower
low swing tops. The highest points of two consecutive swing tops are joined by a straight line and
extended towards right. 

This will have a slope down wards. So this line is termed as falling trend line. It visually represents the
down trend and offers resistance to the future swing tops. If the next swing top takes resistance at this
straight line, then this line becomes a valid down trend line.

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Observe after confirmation of trend at confirming point, how volume has increased. If we get two more
swing lows above the rising trend line or two more swing highs below the falling trend line, we can
redraw the lines. These lines with increased slope represents increased momentum of the trend.

GAP WAVE THEORY

A gap is defined as an unfilled space or interval. On a technical analysis chart, a gap

represents an area where no trading takes place. On the Japanese candlestick chart, a window is
interpreted as a gap.
In an upward trend, a gap is produced when the highest price of one day is lower than the
lowest price of the following day. Thus, in a downward trend, a gap occurs when the lowest price of any
one day is higher than the highest price of the next day.

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Types of gaps
There are four different types of gaps, excluding the gap that occurs as a result of a
stock going ex-dividend. Since each type of gap has its own distinctive implication, it is very important to
be able to distinguish between such gaps.

 Breakaway gap occurs when prices break away from an area of congestion. When the price is
breaking away from a triangle (Ascending or Descending) with a gap then it can be implied that
change in sentiment is strong and coming move will be powerful. One must keep an eye on the
volume. If it is heavy after the gap is formed then there is a good chance that market does not return
to fill the gap. When the price is breaking away on a low volume, there is a possibility that the gap
will be filled before prices resume their trend.

 Common gap is also known as area gap, pattern gap or temporary gap. They tend to occur when
trading is bound between support and resistance level on a short span of time and market price is
moving sideways. One can also see them in price congestion area. Usually, the price moves back or
goes up in order to fill the gaps in the coming days. If the gap is filled, then they offer little in the
way of forecasting significance.

 Exhaustion gap signals end of a move. These gaps are associated with a rapid, straight-line
advance or decline. A reversal day can easily help to differentiate between the Measuring gap and the
Exhaustion gap. When it is formed at the top with heavy volume, there is significant chance that the
market is exhausted and prevailing trend is at halt which is ordinarily followed by some other area
pattern development. An Exhaustion gap should not be read as a major reversal.

 Measuring Gap is also known as a runaway gap. A measuring gap is formed usually in the half
way of a price move. It is not associated with the congestion area, it is more likely to occur
approximately in the middle of rapid advance or decline. It can be used to measure roughly how
much further ahead a move will go. Runaway gaps are not normally filled for a considerable period
of time.

Relative Strength Analysis

Relative strength is a momentum investing technique that compares the performance of a
stock, exchange-traded fund (ETF) or mutual fund to that of the overall market. By using specific
calculations, investors can identify the strongest performers compared to the overall market, creating
recommendations for investments. When used as part of the aforementioned investment strategy, relative
strength assumes a stock whose price has been rising will continue its upward trajectory.

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 Relative strength analysis is simply dividing one market element by another. If this number is increasing,
the one you divided it into is stronger; if this number is decreasing, the one you divided by is stronger.
You can use this to compare a market sector to the economy in general, or you can pick a company and
compare it to the sector’s performance.

Benefits of Relative Strength Analysis

 "Relative strength" represents measuring the performance of one security's price performance to
another.
 Many investors believe a lower-priced security or the one that has performed the worst over a
given time will be the one to buy.
 Creating a process to perform relative strength analysis can help show an investor which areas of
the economy are performing and which are not good places to invest.

Differences between Fundamental Analysis and Technical Analysis

1. Purpose of Fundamental and Technical Analysis
The purpose of fundamental analysis is to forecast share prices based on economic, industry and the
company statistics and facts. Technical Analysis mostly focuses on the internal market statistics and data.
2. Long-term & Short-term Price Movement in Fundamental and Technical Analysis
For long-term investments decisions it makes much more sense to use a fundamental analysis. A
fundamentalist is that investor who invests in long term projects.
Technical analysis only determines short term price changes and trends. A technician is that investor who
only purchases stock on short term basis
3. Value of Share in Fundamental and Technical Analysis
A fundamental analysis as mentioned earlier makes and intrinsic value estimate of the shares and
purchases are made once the market price is determined to be less than the intrinsic value.
Technical analysis follows the concept of there is no real value of stock, it is all dependent on the demand
and supply market forces.

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4. Finding the trend in Fundamental and Technical Analysis
Fundamental analysis does not involve the process of finding out past price trends and the faced
fluctuations. Technicians however, believe that past trends will be re-current and will probably occur
again. In technical analysis charts and tools with trends are used to create conclusions on the price
movements.
5. Assumptions
No assumptions are made in fundamental analysis, however in technical techniques, assumptions such as
similar price trends and so much more are made.
6. Decision Making in Fundamental and Technical Analysis
The fundamental technique analyses financial statements, forecasts, management quality and the earnings
and growth trends. They then make judgments related to the pricing based on subjective opinions from
the available information and statistics. Technical analysts pay attention to the market trends to find out
what it has to say. The market’s opinion is crucial and important in forecasting stock prices and making
investment decisions.
7. Usefulness of Fundamental and Technical Analysis
Fundamental analysis is useful in identifying undervalued or overprices stocks. This is because it
compares the intrinsic value and the market price. An intrinsic value is the real value of a stock price
tabulated after full consideration of all business aspects including both the tangible and intangible
features. Technical analysis is useful in the process of timing a purchase or sells order.
'Efficient Market Hypothesis - EMH'
The Efficient Market Hypothesis (EMH) is an investment theory whereby share prices reflect all
information and consistent alpha generation is impossible. Theoretically, neither technical nor
fundamental analysis can produce risk-adjusted excess returns, or alpha, consistently and only inside
information can result in outsized risk-adjusted returns. According to the EMH, stocks always trade at
their fair value on stock exchanges, making it impossible for investors to either
purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to
outperform the overall market through expert stock selection or market timing, and the only way an
investor can possibly obtain higher returns is by purchasing riskier investments.
Weak version of EMH- The weak version of EMH says that this information is past prices and
trading volumes. This type has the strongest support but it is the least significant, as everyone has
access to more information than past trading data. For example, company earnings, indebtment,
product profile, among other facts (that are called fundamentals). Therefore not much is said about the
possibility of investors beating the market or not. Nevertheless, it has an interesting consequence: it
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 would be of no use to perform technical analysis (which is stock price prediction based exclusively on
past trading data, in contrast to fundamental analysis, which studies the financial performance of the
corporation).
Semi-strong EMH- A stronger flavor of EMH, called semi-strong, says that the information in
question is all which is publicly available. This version is the most interesting for our case because, as
investors, that is exactly the information that we have access to, so if semi-strong EMH is true, then it
is useless for us to analyze stock in an attempt to separate winners from losers.
Strong EMH- There is a stronger version, or strong EMH, which is based on all information, public
or private. This one has evidence against. Therefore, it is illegal to use insider information for trading,
as it would mean insiders taking profits from the general public and thus pushing them away from
stock trading, something that society doesn't want. Corporate officers can buy their corporations'
stock, but when they do they have to inform the government, and that information is made public so
that their purchase becomes a publicly-known fact.
Implications of EMH
The EMH version that most interests us (semi-strong) has strong factual support, although it is
arguable to say that it is conclusive. Personally I take it to be not totally true but to a high degree, and
that level of acceptance is enough for inferring some important practical conclusions:
 Stock picking takes, in the best of cases, a lot of work to be just feebly fruitful, so there are
probably better things to do with our resources.
 Instead of picking stocks, it makes sense to buy passively-managed funds with low commissions,
such as various ETFs, to obtain the market's average returns.
 If we are hiring professionals to do stock picking for us (which happens, for example, when we
purchase shares of an actively-managed fund) their fees shouldn't be too high, because the potential
benefits aren't.
 Whenever we attempt to beat the market, by performing security picking ourselves or through a
professional (fund manager), lets consider the rationale behind the EMH, to identify potential
sources of market inefficiency. For example, we better not try to beat the market by analyzing
large-cap companies, because lots of people are doing it, with the same information that is available
to us. Instead, coming to know a small company and a niche market could put us (or our fund
manager) in an advantageous position compared to the rest of the market. Therefore, active
management sounds like a better idea for small-cap funds than for large.

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  Don't feel too bad if you bought a security and then its price fell, you only were as silly (or
intelligent) as that fabulous team called the market. There are other better criteria for judging your
portfolio-building skills.

Capital Market Theorem

Capital market theory is a positive theory in that it hypothesis how investors do behave rather than,

How investors should behave, as, in the case of Modem Portfolio Theory (MPT). It is reasonable
 "to view capital market" theory; as an extension of portfolio theory, but it is important to understand that
MPT is not based on the validity, or lack thereof, of capital market theory. The capital market theory
builds upon the Markowitz portfolio model. The main assumptions of the capital market theory are as
follows:
Capital Market Theorem Assumptions

1. All Investors are Efficient Investors - Investors follow Markowitz idea of the efficient frontier and
choose to invest in portfolios along the frontier.
2. Investors Borrow/Lend Money at the Risk-Free Rate - This rate remains static for any amount of
money.
3. The Time Horizon is equal for All Investors - When choosing investments, investors have equal
time horizons for the chosen investments.
4. All Assets are Infinitely Divisible - This indicates that fractional shares can be purchased and the
stocks can be infinitely divisible.
5. No Taxes and Transaction Costs -assume that investors' results are not affected by taxes and
transaction costs. 
6. All Investors Have the Same Probability for Outcomes -When determining the expected return,
assume that all investors have the same probability for outcomes.
7. No Inflation Exists - Returns are not affected by the inflation rate in a capital market as none
exists in capital market theory. 
8. There is No Mispricing Within the Capital Markets - Assume the markets are efficient and that no
mispricing within the markets exist.

Capital Asset Pricing Model (CAPM)

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The capital asset pricing model is a model that describes the relationship between systematic risk and  expected
return for assets, particularly stocks. CAPM is widely used throughout finance for the pricing of risky  securities,
generating expected returns for assets given the risk of those assets and calculating costs of capital.

CAPM formula and calculation

CAPM is calculated according to the following formula:

Ra = Rrf+[ Ba.( Rm-Rrf)]

 Where: Ra = Expected return on a security

Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market

The CAPM formula is used to calculate the expected return on investable asset. It is based on the premise
that investors have assumptions of systematic risk (also known as market risk or non-diversifiable risk)
and need to be compensated for it in the form of a risk premium – an amount of market return greater
than the risk-free rate. By investing in a security, investors want a higher return for taking on additional
risk.

 The “Ra” notation above represents the expected return of a capital asset over time, given all of
the other variables in the equation.  
 The “Rff” notation is for the risk-free rate, which is typically equal to the yield on a 10-year
US government bond.  The risk-free rate should correspond to the country where the investment
is being made, and the maturity of the bond should match the time horizon of the investment.  

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  The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk (volatility of
returns) reflected by measuring the fluctuation of its price changes relative to the overall market.
In other words, it is the stock’s sensitivity to market risk..
Assumptions of CAPM
(i) Investors seek return tempered by risk: they are risk-averse and seek to ma their terminal wealth.
(ii) Investors can borrow and lend at the risk-free rate.
(iii) There are no market frictions such as transactions costs, taxes, or restriction short-selling.
(iv) Investors agree on the number and identity of the factors that are important systematically in pricing
assets.
(v) There are no riskless arbitrage profit opportunities.

Advantages of the CAPM

The CAPM has several advantages over other methods of calculating required return, explaining why it
has been popular for more than 40 years:
 It considers only systematic risk, reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially eliminated.
 It is a theoretically-derived relationship between required return and systematic risk which has
been subject to frequent empirical research and testing.
 It is generally seen as a much better method of calculating the cost of equity than the dividend
growth model (DGM) in that it explicitly considers a company’s level of systematic risk relative to the
stock market as a whole.
 It is clearly superior to the WACC in providing discount rates for use in investment appraisal.

Arbitrage Pricing Theory

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to
the capital asset pricing model (CAPM). Unlike the CAPM, which assume markets are perfectly efficient,
APT assumes markets sometimes misprice securities, before the market eventually corrects and securities
move back to fair value. Using APT, arbitrageurs hope to take advantage of any deviations from fair
market value. However, this is not a risk-free operation in the classic sense of arbitrage, because investors
are assuming that the model is correct and making directional trades – rather than locking in risk-free
profits.
Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's
returns can be predicted using the linear relationship between the asset’s expected return and a number of
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macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from
a value investing perspective, in order to identify securities that may be temporarily mispriced.

Where: E(rj) – Expected return on asset, rf  – Risk-free rate, ßn – Sensitivity of the asset price to
macroeconomic factor n, RPn  – Risk premium associated with factor n

The beta coefficients in the APT model are estimated by using linear regression. In general, historical
securities returns are regressed on the factor to estimate its beta.

For example, the following four factors have been identified as explaining a stock's return, and its
sensitivity to each factor and the risk premium associated with each factor have been calculated:

Gross domestic product growth: ß = 0.6, RP = 4%

Inflation rate: ß = 0.8, RP = 2%
Gold prices: ß = -0.7, RP = 5%
Standard and Poor's 500 index return: ß = 1.3, RP = 9%
The risk-free rate is 3%.
Using the APT formula, the expected return is calculated as:
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

Assumptions of Arbitrage pricing Theory-

1. The investors have homogeneous beliefs/expectations
2. The investors are risk ever utility maximisers
3. The market are perfect so that the factors like transaction costs are not relevant.
4. The security return are generated according to a factor model.
5. Risk-returns analysis is not the basis.

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