Research Journal of Finance and Accounting www.iiste.org ISSN 2222-1697 (Paper) ISSN 2222-2847 (Online) Vol.12, No.4, 2021 1 Robust Application of the Arbitrage Pricing Theory and the Test for Volatility in the Stock Market: Evidence from Nigeria Dada, Samuel Obafemi Kolapo, Funsho Tajudeen Mokuolu, Joseph Oluseye Alabi, Kehinde Miracle Department of Finance, Ekiti State University, Nigeria Abstract This study examined the presence of the arbitrage pricing theory as well as volatility in the Nigerian stock market between 1986 and 2018. The study used stock returns as the dependent variable and also used oil price, exchange rate, inflation rate, interest rate, industrial output and real gross domestic product as independent variables. The classical Ordinary Least Square revealed that industrial output has positive effect on stock returns in the short run while the ARDL revealed that inflation has a negative effect on stock returns in the long run. Also, the ARCH and GARCH technique revealed that volatility is evidently high and persistent while the Granger Causality test revealed a unidirectional causality running from inflation and interest rates to stock returns and a bi-directional causal relationship between exchange rate and stock returns. Therefore, it can be concluded that the APT is valid in the Nigerian stock market. Hence, it was recommended that short term investors should pay more attention to the industrial output as diversification to other sectors like agriculture is highly encouraged. Also, the government should adopt policies such as substantial tax reliefs, grants and import substitution strategies to boost industrial output to ensure substantial stock returns in the short run. Invariably, such attempt to boost industrial output will increase competition and efficiency and reduce cost in the economy, coupled with other strategies such as floor and ceilings of macroeconomic rates, inflation will be reduced and become relatively stable to keep stock returns attractive. Keywords: Asset Pricing, Arbitrage Pricing, Stock Returns, Macroeconomic Volatility JEL Classification Codes: G1, O4, E3, E6 DOI: 10.7176/RJFA/12-4-01 Publication date: February 28 th 2021 1.0 INTRODUCTION The financial system is the impetus of every economy, this system encompasses regulatory institutions and other players within the economy especially the financial market and more specifically the stock market. In consonance with the above, a major growth spurring activity within every stock market is the flow of investments in a bid to make capital available within the economy. However, investment is at its best when investors make right decisions irrespective of the vagaries in the market. In a bid to make such decisions, the prices and expected returns on assets are considered together with their accompanying risks, this is the major thrust of the Markowitz model, Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) as propounded by Markowitz (1959), Sharpe (1964) and Ross (1976) respectively. Apparently, in a bid to make proper decisions as regards investor’s portfolio, the pricing of securities must be considered. Such prices are however a function of risk and other information made available in the market. Meanwhile, as a result of the shortcomings of the two previous models, the Arbitrage Pricing Theory has been considered in literature as more pragmatic approach to asset pricing as authenticated by Chen, Roll and Ross (1986). The concept of arbitrage simply refers to the act of taking overvalued or undervalued securities at high prices in markets that are inefficient with little or no risk attached, making profit from its sales and buying assets which are underpriced as a result (Umoru & Iweriebor, 2017). As simple as it may sound, this process is influenced by macroeconomic factors that must not be neglected while making such vital investment decisions as the market is not perceived to exist in isolation independent of other macroeconomic factors. In Nigeria, as a result of the economic recession that hit the global financial markets, investors were in a haste to dispose financial assets held in a bid to exit the market especially in a dynamic world where other investments like real estate are opening up (Abdullahi, 2011). As a result, can this shock exit mean that the APT is valid in the Nigerian Stock Market? Or is there still hope for investment in the stock market considering the macroeconomic factors affecting the returns on securities, much more beyond the reach of market forces in Nigeria? Meanwhile, it is also pertinent to note that validity of the APT has been tested in various markets across the world including Nigeria (Umoru & Iweribor, 2017; Johansson & Petersson, 2018; Elshqirat, 2019), however, there still exists absence of consensus as to the validity of the APT in the market especially in Nigeria where Umoru and Iweriebor (2017) as well as Oyetayo and Adeyeye (2017) discovered that it is valid while Monogbe, Edori and Iki (2016) found it to be invalid and inapplicable in the same market. As a result, this study seeks to test for the validity of the APT in Nigeria. This will be done by moving a step further by the way of estimation techniques through the use of the classical Ordinary Least Squares (OLS) to examine the subject matter in the short run, the Auto Regressive Distributed Lag Modelling technique to examine the matter in the long run, the Auto Regressive