Alternative Investment and Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT):  If we know the make-up of a target alternative investment portfolio, for example the asset class, geography, industry distribution, leverage, etc. then a portfolio can be generated that has the same risk/return characteristics as the target portfolio and therefore it should be priced (valued) the same.

• where
  • Fn is factor loading n or the nth systematic risk factor that determines the return on target portfolio i, Ri.
  • and εj is the risky asset's idiosyncratic random shock with mean zero.

Call DerivActiv at 1-866-200-9012 to speak with an expert on valuing alternative investments under Topic 820.

Alternative Investments and APT—The Law of One Price

The fundamental foundation for the arbitrage pricing theory is the law of one price, which states that two identical assets will sell for the same price, because if they do not, then a no-risk profit could be made by arbitrage—buying the item in the cheaper market then selling it in the more expensive market.

Another implication of the law of one price used in arbitrage pricing theory is that even if they are not identical—items should cost the same if their return and risk are identical.  The justification for this is that the primary reason for the purchase of a financial instrument is to earn a return for a certain amount of risk—no other aspect of the financial instrument matters.  Hence, the law of one price requires that any two financial instruments or portfolios that have the same return-risk profile should sell for the same price.  If this is not true, then a profit can be made by selling the security or portfolio with the lower return and buying the higher return portfolio.

Arbitrage Pricing Theory as it Relates to Valuation of Alternative Investments

DerivActiv incorporates arbitrage pricing theory as a foundation of valuing the fair value of alternative investments.  If we can ascertain the fund objective, fund management style, geographic focus, asset classes, industry distribution and leverage of a target AI portfolio then we can construct a portfolio that has the same risk/return characteristics as the target portfolio and therefore should be priced equivalently. We use a process where we create a simulation of the alternative investment portfolio, based on similar attributes, and we use it to compare results to the target portfolio. The simulated portfolio helps us verify that the reported NAV and returns are accurate and allows us to provide defendable valuations for ASC 820 compliance.  The simulated portfolio is made up of observable market securities that are actively traded.

DerivActiv can value your alternative investments and help you comply with ASC 820.  For more information or call 866-200-9012.