Arbitrage Pricing Theory

Economics
Stephen A. Ross
Franco Modigliani Professor of Financial Economics and Professor Finance at the MIT Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA USA

Ross is suggested a possible Nobel Prize winner “for his arbitrage pricing theory and other fundamental contributions to finance”

Finance is another area of economic research not recently recognized by the Nobel Prize committees: the last “pure” finance Prize was in 1997, and it went to Robert C. Merton and Myron S. Scholes for “a new method to derive the value of derivatives.”

Stephen Ross has been described by a peer as “the greatest living finance scholar.” Of course, the Nobel Prize is generally awarded for a specific contribution rather than for lifetime achievement. He has invented several theories and concepts fundamental to finance, among which are: arbitrage pricing theory, agency theory, risk-neutral pricing, and the binomial model for pricing derivatives. Here it is suggested that, among all these contributions, Ross may be awarded the Nobel Prize specifically for his arbitrage pricing theory. Ross published a paper entitled “The Arbitrage Theory of Capital Asset Pricing” in the Journal of Economic Theory in 1976. This is his third most cited journal article, with over 900 citations to date. The paper was supplemented with a 1980 article in the Journal of Finance entitled “An Empirical Investigation of the Arbitrage Pricing Theory,” co-authored with Richard Roll. Arbitrage pricing theory says that the expected return on a financial asset can be determined by a combination of market indices and other independent macroeconomic factors. It is often compared, by contrast, to the Capital Asset Price Model (CAPM) in that the Arbitrage Pricing Theory (ACT) uses more flexible assumptions than the CAPM, which is market based. A mispriced asset under ACT analysis gives the arbitrageur the opportunity to short the asset while going long on a group of securities to obtain, according to the theory, a risk-free profit. Recognizing the ACT with a Nobel Prize might be expected since the CAPM was singled out by the Nobel committee in its 1990 Prize to Harry M. Markowitz, Merton H. Miller, and William F. Sharpe. Nobel Prizes that extend or complement others are not infrequent.

Commentary on the Economics Laureates by David A. Pendlebury, Analyst, Thomson Reuters