Arbitrage Pricing Theory

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Summary

What is Arbitrage Pricing Theory?

Arbitrage Pricing Theory (APT) is an alternative approach and model to asset pricing then the Capital Asset Pricing Model (CAPM). It was developed by economist Stephen Ross in 1976 and is based purely on arbitrage arguments. It is an equilibrium model of stock returns in which returns are specified to be a linear function of possibly many factors.

Arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets and thereby making a risk free profit.

APT holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient. The model derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by model. If the price diverges, arbitrage should bring it back into line.

Typical APT Factors

These involve the systematic risk that cannot be reduced by the diversification of an investment portfolio. Examples are sudden, unexpected changes in:

Inflation
Gross National Product (GNP) / Gross Domestic Products (GDP)
Corporate bond spreads
Commodities prices
Market indices
Exchange rates
Other economic factors
Industry characteristics

This in contrast to the CAPM, in which returns are specified to be a linear function of only one factor, the systematic (non-diversifiable) risk.

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