Staff Report 189

Measuring the Pricing Error of the Arbitrage Pricing Theory

Guofo Zhou
John F. Geweke

Published March 1, 1995

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.

Published In: Review of Financial Studies (Vol. 9, No. 2, Summer 1996, pp. 557-587)

Download Paper (pdf)