Arbitrage pricing theory (APT) is an asset pricing model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors. Created in 1976 by Stephen Ross, this theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables. The arbitrage pricing theory describes the price where a mispriced asset is expected to be. APT is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors.

Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. A mispriced security will have a price that differs from the theoretical price predicted by the model. By going short an overpriced security while concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in a position to make a theoretically risk-free profit.





Introduction To Risk Management

Related Articles
  1. Trading

    Understanding Arbitrage Pricing Theory

    Investors use the arbitrage pricing theory to identify an asset that’s incorrectly priced.
  2. Trading

    Arbitrage Pricing Theory: It's Not Just Fancy Math

    What are the main ideas behind arbitrage pricing theory? We provide a simple explanation of the model and how to use it.
  3. Investing

    Capital Asset Pricing Model - CAPM

    CAPM is a model that describes the relationship between risk and expected return.
  4. Trading

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  5. Investing

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  6. Investing

    The Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  7. Investing

    Taking Shots At CAPM

    Find out why many investors think the capital asset pricing model is full of holes.
  8. Trading

    Arbitrage and Pairs Trading

    At a basic level, arbitrage is the process of simultaneously buying and selling the same (or equivalent) securities on different markets to take advantage of price differences and make a profit. ...
  9. Trading

    Valuation Models: Apple’s Stock Analysis With CAPM

    The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the asset’s return.
  10. Trading

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
Trading Center