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What is arbitrage pricing theory (APT)?

Arbitrage Pricing Theory (APT) is a financial model used to explain the relationship between the expected returns of an asset and its underlying risk factors. APT suggests that the expected return of an asset can be determined by its sensitivity to various macroeconomic factors. These factors, also known as systematic risks or risk factors, can include changes in interest rates, inflation, GDP growth, or industry-specific variables.

According to APT, the expected return of an asset is a linear function of its exposures to different risk factors, with each factor having a specific weight or coefficient. APT assumes that investors are risk-averse and will require higher returns for taking on greater exposure to these risk factors.

The theory states that if an asset’s expected return does not align with the predicted return based on its risk exposures, an opportunity for arbitrage exists. Arbitrageurs can take advantage of the mispricing by buying undervalued assets and simultaneously selling overvalued assets. This arbitrage activity helps drive prices towards their fair values and ensures market efficiency.

APT differs from the Capital Asset Pricing Model (CAPM) by considering multiple risk factors instead of just the market risk factor. APT provides a more flexible framework for analyzing asset pricing, as it allows for a broader range of risk factors that may influence an asset’s returns.

It’s worth noting that APT is a theoretical framework and requires specific assumptions to hold true for its predictions to be valid. Additionally, identifying and accurately quantifying the relevant risk factors can be challenging in practice.