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. Tech

    CAPM vs. Arbitrage Pricing Theory: How They Differ

    Both project the expected rate of return given the level of risk assumed, but they consider different variables.
  2. 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.
  3. Investing

    Capital Asset Pricing Model - CAPM

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

    The Capital Asset Pricing Model: an Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  5. 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.
  6. Investing

    Taking Shots At CAPM

    Find out why many investors think the capital asset pricing model is full of holes.
  7. 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?
  8. 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.
  9. Investing

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
Frequently Asked Questions
  1. Can I fund a Traditional IRA, a 403(b) or a Roth IRA using pension money?

    Can pension money be used to fund other retirement accounts?
  2. What are unregistered securities or stocks?

    Before securities, like stocks, bonds and notes, can be offered for sale to the public, they first must be registered with ...
  3. How does a company move from an OTC market to a major exchange?

    The over-the-counter market is not an actual exchange like the NYSE or Nasdaq. Instead, it is a network of companies that ...
  4. Can I roll a traditional IRA into a 529 college account for my grandchild?

    The short answer: Not without paying taxes. But as with much of the tax code, there are various nuisances and exemptions ...
Trading Center