how the arbitrage pricing theory works
the arbitrage pricing theory was developed by the economist stephen ross in 1976 as an alternative to the capital asset pricing model capm 1 unlike the capm which assume markets are perfectly efficient apt assumes markets sometimes misprice securities before the market eventually corrects and securities move back to fair value using apt arbitrageurs hope to take advantage of any deviations from fair market value however this is not a risk free operation in the classic sense of arbitrage because investors are assuming that the model is correct and making directional trades rather than locking in risk free profits mathematical model for the aptwhile apt is more flexible than the capm it is more complex the capm only takes into account one factor market risk while the apt formula has multiple factors and it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks the factors as well as how many of them are used are subjective choices which means investors will have varying results depending on their choice however four or five factors will usually explain most of a security s return for more on the differences between the capm and apt read more about how capm and arbitrage pricing theory differ apt factors are the systematic risk that cannot be reduced by the diversification of an investment portfolio the macroeconomic factors that have proven most reliable as price predictors include unexpected changes in inflation gross national product gnp corporate bond spreads and shifts in the yield curve other commonly used factors are gross domestic product gdp commodities prices market indices and exchange rates example of how arbitrage pricing theory is usedfor example the following four factors have been identified as explaining a stock s return and its sensitivity to each factor and the risk premium associated with each factor have been calculated using the apt formula the expected return is calculated as 