Arbitrage Pricing Theory

See Also:
Cost of Capital
Cost of Capital Funding
Capital Asset Pricing Model
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Arbitrage Pricing Theory Definition

The arbitrage pricing theory (APT) is a multifactor mathematical model used to describe the relation between the risk and expected return of securities in financial markets. It computes the expected return on a security based on the security’s sensitivity to movements in macroeconomic factors. Then use the resultant expected return to price the security.
The arbitrage pricing theory is based on three assumptions. First, that a factor model can be used to describe the relation between the risk and return of a security. Then, idiosyncratic risk can be diversified away. Finally, efficient financial markets do not allow for persisting arbitrage opportunities.
In addition, the arbitrage pricing theory calculates the expected return for a security based on the security’s sensitivity to movements in multiple macroeconomic factors. Whereas the standard capital asset pricing model (CAPM) is a single factor model, incorporating the systematic and firm specific risk related to the overall market return, the arbitrage pricing theory is a multifactor model.
Then, set up the arbitrage pricing theory to consider several risk factors, such as the business cycle, interest rates, inflation rates, and energy prices. The model distinguishes between both systematic risk and firm-specific risk. It also incorporates both types of risk into the model for each given factor.

Arbitrage Pricing Theory Formula

The formula includes a variable for each factor, and then a factor beta for each factor, representing the security’s sensitivity to movements in that factor. Because it includes more factors, consider the arbitrage pricing theory more nuanced – if not more accurate, than the capital asset pricing model.
A two-factor version of the arbitrage pricing theory formula is as follows:
r = E(r) + B₁F₁ + B₂F₂ + e 
r = return on the security
E(r) = expected return on the security
F₁ = the first factor
B₁ = the security’s sensitivity to movements in the first factor
F₂ = the second factor
B₂ = the security’s sensitivity to movements in the second factor
e = the idiosyncratic component of the security’s return
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