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. Investing

    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.
  2. 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.
  3. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. But how does ETF arbitrage work?
  4. Investing

    Taking Shots At CAPM

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

    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.
  6. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  7. Investing

    Arbitrage Opportunities in Spread Betting

    While the opportunities are few and far between, investors may use arbitrage to take advantage of price differences in financial spread betting.
  8. Trading

    Trade Takeover Stocks With Merger Arbitrage

    This high-risk strategy attempts to profit from price discrepancies that arise during acquisitions.
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center