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What is Arbitrage Pricing Theory?
Arbitrage Pricing Theory (APT) is a financial model used to determine the expected return of an asset based on its exposure to various risk factors. It is an alternative to the Capital Asset Pricing Model (CAPM) and provides a framework for pricing assets by considering multiple sources of systematic risk.
The main idea behind APT is that the expected return of an asset can be explained by its sensitivity to different risk factors rather than just the overall market risk. APT assumes that the returns of assets are driven by several common factors, such as interest rates, inflation, GDP growth, industry-specific variables, or other macroeconomic indicators.
Below are the key principles involved in Arbitrage Pricing Theory:
Factor Identification: The first step in APT is to identify the relevant risk factors that influence the returns of assets. These factors can be determined through statistical analysis or economic intuition. For example, in a stock market context, factors such as interest rate changes, market volatility, or sector-specific variables may be considered.
Factor Sensitivity Estimation: Once the factors are identified, the next step is to estimate the sensitivity or exposure of an asset to each factor. This is typically done through regression analysis, where historical data is used to analyze the relationship between the asset's returns and the factors' returns.
Factor Pricing: APT assumes that the expected return of an asset is a linear function of its factor sensitivities. The coefficients or factor loadings obtained from the regression analysis are used to price the asset. The asset's expected return is calculated as the sum of the risk-free rate and the product of the factor sensitivities and their corresponding risk premiums.
Arbitrage Opportunities: A key assumption in APT is the absence of arbitrage opportunities. If an asset is mispriced, arbitrageurs would take advantage of the discrepancy by buying or selling the asset until its price adjusts to its fair value. The absence of such opportunities ensures that the pricing model is consistent and free of arbitrage.
APT is a multifactor model that allows for a more nuanced assessment of asset pricing compared to the CAPM, which considers only the market risk. By considering multiple risk factors, APT can better capture the sources of risk that affect asset returns in specific contexts or industries. However, whilst APT offers a more flexible and comprehensive approach to asset pricing, its success relies on the identification and accurate estimation of the relevant risk factors. As with any financial model, APT has its limitations and assumptions that may not always hold in real-world scenarios.