Arbitrage Pricing Theory (APT) is a financial model that seeks to explain the relationship between the expected return of an asset and various factors that influence that return. Developed by economist Stephen Ross in the 1970s, APT differs from the Capital Asset Pricing Model (CAPM) by allowing for multiple sources of systematic risk or factors affecting asset prices.
The key premise of APT is that the expected return of an asset is not solely determined by the overall market risk (as in CAPM) but rather by a linear relationship with several macroeconomic or systematic factors. These factors could include interest rates, inflation, economic indicators, or other relevant variables that impact asset prices.
Components Associated with Arbitrage Pricing Theory
Risk Factors (F): APT assumes that the expected return of an asset depends on several systematic risk factors. These factors are not specified by the model but are assumed to influence asset prices. For example, in the context of stocks, factors could include changes in interest rates, GDP growth, or inflation.
Risk Premiums (B): APT introduces the concept of factor sensitivities or coefficients (B) to represent how sensitive an asset’s return is to changes in each risk factor. The relationship is linear, meaning that the expected return of an asset is the sum of the risk premiums associated with each factor multiplied by the corresponding factor sensitivity.
Expected Return = Risk-Free Rate + (B1 * Risk Premium1) + (B2 * Risk Premium2) + … + (Bn * Risk Premiumn)
Arbitrage Opportunities: APT assumes that there are no arbitrage opportunities, meaning that it is not possible to create a riskless profit by trading portfolios of assets. If an arbitrage opportunity exists, it would allow investors to make a riskless profit, violating the assumptions of APT.
Factor Sensitivities (B): The factor sensitivities are determined through statistical analysis, often using regression techniques. These coefficients help quantify how much an asset’s return is expected to change in response to a one-unit change in each of the relevant risk factors.
Market Price of Risk: APT introduces the concept of the market price of risk, representing the additional expected return that investors require for taking on an additional unit of risk. This concept helps in understanding the risk-return tradeoff in the context of different factors.
Arbitrage Pricing Theory provides a framework for understanding asset pricing by considering the influence of multiple systematic risk factors. By allowing for a broader set of factors than the Capital Asset Pricing Model, APT provides a more flexible and realistic approach to modeling the relationship between risk and return in financial markets.