Definition Arbitrage Pricing Theory. Description.
Arbitrage Pricing Theory (APT) is an alternative model to
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, in contrast
to the CAPM, in which returns are specified to be a linear function of one
factor, the systematic (non-diversifiable) risk.
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.
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