What Is an Arbitrage Pricing Theory?

What Is an Arbitrage Pricing Theory?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

Arbitrage Pricing Theory, often known as APT, is an influential economic theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The theory came from the idea that a security’s returns can be predicted using the relationship between that same security and many common risk factors. Arbitrageurs would take advantage of any deviations from this model to earn risk-free profit.

Related Questions

1. What are some examples of macroeconomic factors in Arbitrage Pricing Theory?

Examples of macroeconomic factors in APT may include changes in inflation rates, changes in levels of industrial production, shifts in the risk premium for the overall market, and unanticipated changes in the steepness of the term structure of interest rates.

2. How does Arbitrage Pricing Theory differ from the Capital Asset Pricing Model?

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While both the Arbitrage Pricing Theory and the Capital Asset Pricing Model (CAPM) help calculate a theoretically appropriate expected rate of return on an asset, they approach it in different ways. APT, unlike CAPM, is multi-factor – associating asset risk with multiple macroeconomic variables, therefore it provides a more flexible and multidimensional view of risk-return relationships.

3. Can Arbitrage Pricing Theory be used for all types of financial assets?

APT can be applied to any type of financial asset as long as the asset’s expected returns bear a linear relationship to a set of predictor variables (common risk factors). This includes not only stocks, but also bonds, mutual funds, futures contracts, and other forms of financial investments.

4. What is an arbitrage strategy?

An arbitrage strategy involves the simultaneous buying and selling of related securities in different markets to take advantage of price or currency discrepancies. The profits come from the difference in prices in the two markets.

5. What is a ‘beta coefficient’ in relation to the Arbitrage Pricing Theory?

In Arbitrage Pricing Theory, the beta coefficient measures the sensitivity of a security’s returns to a particular macroeconomic factor. A high beta implies that the security’s returns are highly influenced by that risk factor, while a low beta suggests less influence.