What Is the Arbitrage Pricing Theory (APT)?

Arbitrage pricing theory (APT) is a 澳洲幸运5官方开奖结果体彩网:multi-factor asset pricing model. It's based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk. It is a useful tool for analyzing portfolios from a 澳洲幸运5官方开奖结果体彩网:value investing perspective, in order to id💦⛄entify securities that may be temporarily mispriced.

The Formula for the Arbitrage 𓆉Pricing Theory Model Is

 $\begin{aligned} &\text{E(R)}_\text{i} = E(R)_z + (E(I) - E(R)_z) \times \beta_n\\ &\textbf{where:}\\ &\text{E(R)}_\text{i} = \text{Expected return on the asset}\\ &R_z = \text{Risk-free rate of return}\\ &\beta_n = \text{Sensitivity of the asset price to macroeconomic} \\ &\text{factor}\textit{ n}\\ &Ei = \text{Risk premium associated with factor}\textit{ i}\\ \end{aligned}$​E(R)i​=E(R)z​+(E(I)−E(R)z​)×βn​where:E(R)i​=Expected return on the assetRz​=Risk-free rate of returnβn​=Sensitivity of the asset pric🐼e to&nbs🍌p;macroeconomicfactor nEi=Risk premium a♛ssociated with factor i​

The 🐭bet♛a coefficients in the APT model are estimated by using linear regression. In general, historical securities returns are regressed on the factor to estimate its beta.

How the Arbitrage Pricing Theory Works

The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to the 澳洲幸运5官方开奖结果体彩网:capital asset pricing model (CAPM). Unlike the CAPM, which assume markets are perfectly efficient, APT assumes 澳洲幸运5官方开奖结果体彩网:markets sometimes♏ misprice securities, before the market eventually corrects and securit🤪ies move back to fair value. Using APT, arbitrageurs hope to take advantage of any deviation🌊s from fair market value.

However, this is not a risk-free operation in the classic sense of 澳洲幸运5官方开奖结果体彩网:arbitrage, because investors are assuming t⛎hat the model is correct and making directional trades—rather than locking in risk-free profits.

Mathematical Model for the APT

While APT is more flexible than the CAPM𒐪, it is more complex. The CAPM only takes into account one factor—market r✤isk—while the APT formula has multiple factors. And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks.

The factors as well as how many of them are used are subjective choices, which means investors will have varying results depending on their choice. However, four or five factors will usually explain most of a security's return. (For more on the differences between the CAPM and APT, read more about how 澳洲幸运5官方开奖结果体彩网🌼:CAPM and arbitrage pricing theory differ.)

APT factors are the systematic risk that cannot be reduced by the diversification of an investment portfolio. The macroeconomic factors that have proven most reliable as price predictors include unexpected changes in inflation, 澳洲幸运5官方开奖结果体彩网:gross national product (GNP), corporate bond spreads and shifts in the yield curve. Other commonly used factors are 澳洲幸运5官方开奖结果体彩网:gross domestic product (GDP), commodities p▨rices, market ind꧋ices, and exchange rates.

Example of How Arbitrage Pricing Theory Is Used

For example, the following four factors have been identified as explaining a stock's return and its sensitivity to each factor and the risk premium associated with each factor have been calculated:

• Gross domestic product (GDP) growth: ß = 0.6, RP = 4%
• Inflation rate: ß = 0.8, RP = 2%
• Gold prices: ß = -0.7, RP = 5%
• Standard and Poor's 500 index return: ß = 1.3, RP = 9%
• The risk-free rate is 3%

Using the AP🌸T formula, the expected ret🍬urn is calculated as:

• Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

The Bottom Line

Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's returns can be forecasted with the linear relationship between an asset’s return and a number of macroeconomic factors that affect the asset’s risk.

Arbitrage pricing theory assumes that markets sometimes misprice securities before they are corrected andཧ move back to fair va﷽lue.