BusinessHABTactical arbitrage pricing: Arbitrage Pricing Theory is a general theory of asset pricing that uses a linear function which includes various macro-economic factors or theoretical market indices to model an asset’s expected return.
At the core APT’s main function is to realize that only few systematic factors can affect an asset’s average returns. Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors included within the model.
The APT was a revolutionary model used for pricing an asset because it allows users to customize their model to the security being analyzed. As with other pricing models, it helps user to decide whether an asset is undervalued or overvalued and so people can profit from this information.
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Tactical arbitrage pricing
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While APT does rely upon static equilibrium arguments, it allows a world where occasional mispricings occurs. Investors constantly seek information about these mispricings and exploit them as they find them.
It claims that investors will ‘price’ these factors precisely because they are sources of risk that cannot be diversified away, which means they will demand compensation in terms of expected returns for holding securities exposed to these risks.
APT can also bring benefit for asset/portfolio managers when they try to test whether their portfolios are exposed to certain factors.
They can choose their own systematic profile of risk and returns by selecting a portfolio with it own peculiar array of betas(to specific factor).
In short, the APT allows for an industry of information collectors, risk arbitrageurs and speculators. It allows diversified types of investors as well as evolving types of risks.
In other words, it describes a world somewhat closer to the world in which we live right now.
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Tactical arbitrage pricing
About Umbrella Network
Umbrella Network is a scalable, cost-efficient, and community-owned oracle for the DeFi and blockchain community. Its Layer 2 technology uses the latest advances in Merkle tree technology to write multiple data points on a single on-chain transaction, allowing for the batching of data to smart contracts accurately, securely, and inexpensively.
Umbrella believes a community-owned oracle is not only possible but essential to creating a truly decentralized financial system.
Tactical arbitrage pricing
It is hard to forecast the exact events that may change stock’s price in the future, but we can measure the sensitivity towards changes in each factor by β through factor model.
The APT assumes that these opportunities will be taken advantage of until prices shift and the arbitrage opportunities disappear.
This provides a justification for the use of empirical based factor models in pricing securities; if the model were inconsistent, the arbitrage opportunity will exist and so the prices would adjust.
As I clarified before, it is hard to predict the expected return accurately and consistently, partially because every asset is always exposed to the arbitrage market.
Which implies that if the expected return of the asset is high, then more people will enter into the market for this asset by which the returns will be diluted in the end.
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Tactical arbitrage pricing
So one of the practical uses of APT is to integrate with Long-Short Equity Strategy based on factor model ranking system.
Because the expected returns calculated by APT model imply the returns when the market is fully arbitraged.
If you know what the expected return of an asset(given that the market is arbitraged) and you assume that the market will be mostly arbitrated over the timeframe on which you are trading.
You can construct a ranking system based on it for Long-Short Equity Strategy.
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Tactical arbitrage pricing
First, you should estimate the expected returns for each asset on the market and rank them.
Based on the strategy, we should long the top percentile and short the bottom percentile.
You will make money on the difference in returns eventually. Because you expect the high-ranking assets’ value to increase in the future such as x% and the low-ranking asset’s value to decline x% later(The market return is Rm).
You can then make total (Rm + X%) — (Rm — X%) = 2X% in the end.
By using Long-Short Equity strategy, you actually accept the fact that you can never make the exact prediction on single asset.
Instead, you choose a bunch of stocks and make your prediction on them.
You can make money through the spread and increase your winning chance dramatically as long as the model is 51% accurate(we can predict the expected returns for a group of 1000 assets as the errors average out.).
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Tactical arbitrage pricing
Umbrella Network is pleased to announce an arbitrage-free pricing model for crypto options.
This new crypto options offering will bring previously unavailable, Wall Street level data sophistication to the DeFi ecosystem, on par with the S&P 500 in terms of granularity in available strike price and expiration levels.
There is a lot to unpack in the statement above so let’s go through and review what we mean, and why we believe this is a major advancement to the current status quo.
Crypto options have always been a step behind options data in traditional finance (such as the ones on the S&P500). There is currently a lack of data and liquidity within the DeFi options space, specifically on strikes or maturities, which has led to gaps in values for options prices.
Tactical arbitrage pricing
This will now no longer be the case with the launch of Umbrella Network’s Arbitrage-Free Pricing Model, which will provide efficient prices similar to those available to Wall Street traders, offering a full overview of options markets, prices that include options with the same maturity, as well as options with the same strike but different maturities.
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Umbrella Network achieves this through a two-step process:
- Collecting much more comprehensive data with an entire data grid of strike prices and expiration dates
- Eliminating outlier data points, and thus minimizing arbitrage opportunities, which are essentially market inefficiencies
While the collecting of data is done via Umbrella Network’s decentralized oracles, the real innovation lies in the economic constraints applied. This ensures that the resulting Implied Volatility curve would be as smooth as that of any S&P 500 traded pair’s.
Tactical arbitrage pricing
This new pricing model would be highly useful for both trading dApps as well as retail users.
A trading dApp can now offer more granular and arbitrage-free options to its users.
The options contracts that can now be offered would be more numerous than any other crypto-options contracts in the market today. This is because the arbitrage opportunities have been removed.
Retailers, on the other hand, can use the Umbrella Network’s Arbitrage-free Options Pricing Model to ascertain whether the options contracts offered on other markets are over-priced or under-priced, and enter into trades much more effectively.
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