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Return, Risk And The Security Market Line - Arbitrage Pricing Theory

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.



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