Understanding Arbitrage Pricing Theory
Arbitrage pricing theory (APT) is a theory of asset pricing that states the expected return of an asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. This theory was developed in 1976 by Nobel Laureate in Economics, Professor Stephen A. Ross. The APT is an alternative to the capital asset pricing model (CAPM) and is based on the concept of arbitrage. Arbitrage is the practice of taking advantage of price discrepancies between two or more markets to make a profit. In the context of the APT, the theoretical market indices represent the different markets and the betas represent the sensitivity of the asset to changes in each index. The APT is a general pricing model that allows for multiple factors that can affect asset prices. This is in contrast to the CAPM model, which is limited to a single factor: the market risk premium. By incorporating multiple factors, the APT provides a more accurate estimate of expected return than the CAPM. Here are some examples of factors that can be used in an APT model:
- The rate of inflation
- Economic growth
- Interest rate changes
- Industry-specific events
- Currency exchange rates
The APT model is used to calculate the expected return of an asset by estimating the betas for each factor and then multiplying each factor’s beta by its expected return. The sum of these products is the expected return of the asset. For example: If a stock has a beta of 1.5 for economic growth, a beta of 0.5 for inflation, and an expected return of 4% for economic growth and 2% for inflation, then the expected return of the stock would be calculated as follows: Expected return = (1.5 x 4%) + (0.5 x 2%) = 6% The APT model is a useful tool for investors and financial analysts, as it allows them to estimate the expected return of an asset based on its sensitivity to various macroeconomic factors.
The APT is a useful tool for investors and financial analysts to estimate the expected return of an asset based on its sensitivity to various macroeconomic factors. By incorporating multiple factors into the model, the APT provides a more accurate estimate of expected return than the CAPM.