## Arbitrage Pricing Theory

Arbitrage Pricing Theory (APT) is a financial theory that aims to explain the relationship between expected returns on assets and their risks. APT suggests that the expected return of a financial asset can be predicted using multiple factors or variables, rather than just the asset’s beta as in the Capital Asset Pricing Model (CAPM).

One of the key assumptions of APT is that in an efficient market, any opportunity for arbitrage (i.e., riskless profit) will be quickly eliminated by rational investors. This means that the expected return of an asset should be proportional to its exposure to each of the factors identified in the APT model.

For example, if an APT model includes factors such as interest rates, inflation, and GDP growth, an asset’s expected return would be determined by its sensitivity to each of these factors. If an asset is more sensitive to inflation, for instance, its expected return would be higher to compensate for the increased risk.

APT is used by financial analysts and investors to estimate the expected returns of different assets and portfolios, taking into account multiple risk factors. By diversifying investments across assets with different factor exposures, investors can potentially reduce their overall risk without sacrificing returns.

Overall, Arbitrage Pricing Theory provides a more flexible and realistic framework for understanding asset pricing compared to the simpler CAPM model.

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