case study on arbitrage pricing theory

An Empirical Investigation of Arbitrage Pricing Theory: A case
Zimbabwe

Petros Jecheche
University of Zimbabwe

ABSTRACT

This study investigates the Arbitrage Pricing Theory for the case of Zimbabwe using time series data from 1980 to 2005 within a vector autoregressive (VAR) framework. The Granger causality tests are conducted to establish the existence of causality among the variables like inflation, exchange rate and Gross Domestic Product. The VAR estimates as shown by the impulse response and variance decomposition together with the Granger causality test show that there is unidirectional causality from Consumer Price Index to Stock Prices. Although the Granger causality test has indicated that there is no causality between RGDP and Stock Prices, the variance decomposition has shown that the real GDP explains deviations in the Stock Prices in the long run. Granger causality tests found no meaningful relationships between Stock Prices and Exchange Rate but considering impulse response functions the effect is significant as early as the first period.

Keywords: Arbitrage, Capital Asset Pricing Model (CAPM), Efficient Market Hypothesis, Vector Auto Regression Model (VAR), Impulse Response, Variance Decomposition.

INTRODUCTION

The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. Both of them are based on the efficient market hypothesis, and are part of the modern portfolio theory. The Efficient Market Hypothesis (EMH) (Fama, 1965), states that at any given time, security prices fully reflect all available information. If the asset is overpriced, then arbitrageurs will short the asset, until reduced demand for purchasing it caused the price to fall. The opposite is true for underpriced securities.
The CAPM is based on several simplifying assumptions and because most of these assumptions

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