This thesis presents an empirical investigation into the Arbitrage Pricing Theory (APT). At the onset of the thesis it is recognised that tests of the APT are conditional on a number of preconditions and assumptions. The first line of investigation examines the effect of the assumed nature of the form of the return generating process of stocks. It is found that stocks follow an approximate factor structure and tests of the APT are sensitive to the specified form of the return generating process. We provide an efficient estimation methodology for the case when stocks follow an approximate factor structure. The second issue we raise is that of the appropriate factors, the role of the market portfolio and the performance of the APT against the Capital Asset Pricing Model (CAPM). The conclusions that we draw are that the APT is robust to a number of specified alternatives and furthermore, the APT outperforms the CAPM in comparative tests. In addition, within the APT specification there is a role for the market portfolio. Through a comparison of the results in chapters 2 and 3 it is evident that the APT is not robust to the specification of unexpected components. We evaluate the validity of extant techniques in this respect and find that they are unlikely to be representative of agents actual unexpected components. Consequently we put forth an alternative methodology based upon estimating expectations from a learning scheme. This technique is valid in respect to our prior assumptions. Having addressed these preconditions and assumptions that arise in tests of the APT a thorough investigation into the empirical content of the APT is then undertaken. Concentrating on the issues that the return generating process must be unique and that the estimated risk premia should be stable overtime the results indicate that the APT does have empirical content. Finally, armed with the empirically valid APT we proceed to analyse the issue of seasonalities in stock returns. The results confirm previous findings that there are seasonal patterns in the UK stock market, however, unlike previous findings we show that these seasonal patterns are part of the risk return structure and can be explained by the yearly business cycle. Furthermore, the APT retains empirical content when these seasonal patterns are removed from the data. The overall finding of this thesis is that the APT does have empirical content and provides a good description of the return generating process of UK stocks.

Monthly returns on twenty-seven Eurobonds from July 1982 to June 1986 were examined. There were no consistent differences in returns based on the country in which a firm is located. There were consistent differences due to industry classification, with energy-related firms exhibiting higher average returns and variances. Excess returns were calculated using the capital asset pricing model and arbitrage pricing theory. The results from calculation of mean average deviation, root mean square, and R2 all indicate that the arbitrage pricing theory was a better descriptor of the Eurobond market. The excess returns were also examined using stochastic dominance. Arbitrage pricing theory never dominated the capital asset pricing model using first-order criteria, but consistently dominated using second-order criteria. The results were discussed in terms of the implications for investors and portfolio managers.

Thesis (MSc)--Stellenbosch University, 2013. / ENGLISH ABSTRACT: In modern theory of finance, the so-called First and Second Fundamental Theorems of Asset Pricing play an important role in pricing options with no-arbitrage. These theorems gives a necessary and sufficient conditions for a market to have no-arbitrage and for a market to be complete. An early version of the First Fundamental Theorem of Asset Pricing was proven by Harrison and Kreps [30] in the case of a finite probability space. A more general version was proven by Harrison and Pliska [31] in the case of a finite probability space and discrete time. In the case of continuous time, Delbaen and Schachermayer [19] introduced a more general concept of no-arbitrage called "No-Free Lunch With Vanishing Risk" (NFLVR), and showed that for a locally-bounded semimartingale price process NFLVR is essentially equivalent to the existence of an equivalent local martingale measure. The goal of this thesis is to review the theory of arbitrage pricing and the extension of this theory to include liquidity risk. At the current time, liquidity risk is a key challenge faced by investors. Consequently there is a need to develop more realistic pricing models that include liquidity risk. We present an approach to liquidity risk by Çetin, Jarrow and Protter [10]. In to this approach the liquidity risk is embedded into the classical theory of arbitrage pricing by having investors act as price takers, and assuming the existence of a supply curve where prices depend on trade size. This framework assumes that the quantity impact on the price transacted is momentary. Using trading strategies that are both continuous and of finite variation allows one to avoid liquidity costs. Therefore, the First and Second Fundamental Theorems of Asset Pricing and the Black-Scholes model can be extended. / AFRIKAANSE OPSOMMING: In moderne finansiële teorie speel die sogenaamde Eerste en Tweede Fundamentele Stellings van Bateprysbepaling ’n belangrike rol in die prysbepaling van opsies in arbitrage-vrye markte. Hierdie stellings gee nodig en voldoende voorwaardes vir ’n mark om vry van arbitrage te wees, en om volledig te wees. ’n Vroeë weergawe van die Eerste Fundamentele Stelling was deur Harrison en Kreps [30] bewys in die geval van ’n eindige waarskynlikheidsruimte. ’n Meer algemene weergawe was daarna gepubliseer deur Harrison en Pliska [31] in die geval van ’n eindige waarskynlikheidsruimte en diskrete tyd. In die geval van kontinue tyd het Delbaen en Schachermayer [19] ’n meer algemene konsep van arbitragevryheid ingelei, naamlik “No–Free–Lunch–With–Vanishing–Risk" (NFLVR), en aangetoon dat vir lokaalbegrensde semimartingaalprysprosesse NFLVR min of meer ekwivalent is aan die bestaan van ’n lokaal martingaalmaat. Die doel van hierdie tesis is om ’n oorsig te gee van beide klassieke arbitrageprysteorie, en ’n uitbreiding daarvan wat likideit in ag neem. Hedendaags is likiditeitsrisiko ’n vooraanstaande uitdaging wat beleggers die hoof moet bied. Gevolglik is dit noodsaaklik om meer realistiese modelle van prysbepaling wat ook likiditeitsrisiko insluit te ontwikkel. Ons bespreek die benadering van Çetin, Jarrow en Protter [10], waar likiditeitsrisiko in die klassieke arbitrageprysteorie ingesluit word deur die bestaan van ’n aanbodkromme aan te neem, waar pryse afhanklik is van handelsgrootte. In hierdie raamwerk word aangeneem dat die impak op die transaksieprys slegs tydelik is. Deur gebruik te maak van handelingsstrategië wat beide kontinu en van eindige variasie is, is dit dan moontlik om likiditeitskoste te vermy. Die Eerste en Tweede Fundamentele Stellings van Bateprysbepaling en die Black–Scholes model kan dus uitgebrei word om likiditeitsrisiko in te sluit.

This study investigates the return generating process underlying the South African stock market. The investigation of the return generating process is framed within the Arbitrage Pricing Theory (APT) framework with the APT reinterpreted so as to provide a conceptual framework within which the return generating process can be investigated. In modelling the return generating process, the properties of South African stock returns are taken into consideration and an appropriate econometric framework in the form of Autoregressive Conditional Heteroscedastic (ARCH) and Generalized Autoregressive Conditional Heteroscedastic (GARCH) models is applied. Results indicate that the return generating process of South African stock returns is described by innovations in multiple risk factors representative of several risk categories. The multifactor model of the return generating process explains a substantial amount of variation in South African stock returns and the ARCH/GARCH methodology is an appropriate econometric framework for the estimation of models of the return generating process. The APT framework is successfully applied to model and investigate the return generating process of South African stock returns.

<p>1.3. Research Questions.</p><p>With this in mind, the research questions of this work are:</p><p>1. Is the Capital Asset Pricing Model still applicable despite the heavy impact of the financial crisis on the financial systems?</p><p>2. What happens to this model when the risk free rate approaches zero?</p><p>3. Is there a relationship between the riskiness of an asset and the risk-free interestrate when the latter is approaching the zero level?</p>

1.3. Research Questions. With this in mind, the research questions of this work are: 1. Is the Capital Asset Pricing Model still applicable despite the heavy impact of the financial crisis on the financial systems? 2. What happens to this model when the risk free rate approaches zero? 3. Is there a relationship between the riskiness of an asset and the risk-free interestrate when the latter is approaching the zero level?

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This dissertation deals with the links between stock market returns and foreign exchange rates, industrial production and exports to Germany in three Central and East European countries (the Czech Republic, Hungary and Poland). The main questions addressed are: "Do macroeconomic factors related to foreign exchange rates and industrial production affect stock market returns in the Visegrad-3? And what is the impact of exports to Germany on those stock returns?" This analysis makes use of panel-data and the Arbitrage Pricing Theory (APT) to produce results. Firstly, foreign exchange rates are found to have a negative effect on stock returns. However the divergence in currency returns between the three countries means that the overall effect may be due to some factors that are not accounted for in this analysis. Secondly, there is a positive, but lagged, association between industrial production and stock returns. Thirdly, exports to Germany from the region are also found to have a positive impact on the stock returns of the Visegrad-3. Finally, there is divergence among the three countries with respect to the relationship between the macroeconomic factors and stock returns. Poland and Hungary are seen to exert a significant amount of influence over the region's stock markets.

Companiesissuing insurance cover, in return for insurance premiums, face the payments ofclaims occurring according to a loss distribution. Hence, capital must be heldby the companies so that they can guarantee the fulfilment of the claims ofeach line of insurance. The increased incidence of insurance insolvencymotivates the birth of new legislations as the European Solvency II Directive.Companies have to determine the required amount of capital and the optimalcapital allocation across the different lines of insurance in order to keep therisk of insolvency at an adequate level. The capital allocation problem may betreated in different ways, starting from the insurance company balance sheet.Here, the running process and efficiency of four methods are evaluated andcompared so as to point out the characteristics of each of the methods. TheValue-at-Risk technique is straightforward and can be easily generated for anyloss distribution. The insolvency put option principle is easily implementableand is sensitive to the degree of default. The capital asset pricing model isone of the oldest reliable methods and still provides very helpful intermediateresults. The Myers and Read marginal capital allocation approach encouragesdiversification and introduces the concept of default value. Applications ofthe four methods to some fictive and real insurance companies are provided. Thethesis further analyses the sensitivity of those methods to changes in the economiccontext and comments how insurance companies can anticipate those changes.

The impact of political and economic events on the asset pricing model described by the arbitrage pricing theory (APTM) was examined in order to establish if they had caused any changes in its specification. It was concluded that the APTM is not stationary and that it must be continuously tested before it can be used as political and economic events can change its specification. It was also found that political events had a more direct effect on the specification of the APTM, in that their effect is more immediate, than did economic events, which influenced the APTM by first influencing the economic environment in which it operated. The conventional approach that would have evaluated important political and economic events, case by case, to determine whether they affected the linear factor model (LFM), and subsequently the APTM, could not be used since no correlation was found between the pricing of a risk factor in the LFM and its subsequent pricing in the APTM. A new approach was then followed in which a correlation with a political or economic event was sought whenever a change was detected in the specification of the APTM. This was achieved by first finding the best subset LFM, chosen for producing the highest adjusted R2 , month by month, over 87 periods from 20 October1991 to 21 June 1998, using a combination of nine prespecified risk factors (five of which were proxies for economic events and one for political events). Multivariate analysis techniques were then used to establish which risk factors were priced most often during the three equal subperiods into which the 87 periods were broken up. Using the above methodology, the researcher was able to conclude that political events changed the specification of the APTM in late 1991. After the national elections in April 1994 it was found that the acceptance of South Africa into the world economic community had again changed the specification of the APTM and the two most important factors were proxies for economic events. / Business Leadership / DBL