Arbitrage Pricing Theory

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Description of Arbitrage Pricing Theory. Explanation.

 

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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