Arbitrage Pricing Theory
Arbitrage Pricing Theory (APT) is a financial theory that predicts the expected return on an asset based on the relationship between that asset and numerous common risk factors. Unlike the Capital Asset Pricing Model (CAPM), which only considers the relationship between an asset and the market as a whole, APT takes into account several factors that may affect the price of an asset.
One of the key principles of APT is the idea of arbitrage, which is the practice of buying an asset at a low price in one market and selling it at a higher price in another market to make a profit. APT assumes that if there are any mispricings in the market, investors will quickly take advantage of them through arbitrage, which will eventually lead to the correct pricing of assets.
For example, let’s say that a stock’s price is influenced by factors such as interest rates, inflation, and company performance. APT would consider how changes in these factors could impact the stock’s expected return, and investors could use this information to make informed decisions about their investments.
Overall, Arbitrage Pricing Theory provides a more comprehensive framework for understanding the relationship between risk and return in financial markets, and it is used by investors and financial analysts to make better investment decisions.
References:
- Learn more about Arbitrage Pricing Theory on Wikipedia