Arbitrage pricing theory
In finance, arbitrage pricing theory (APT) is a multifactor model for asset pricing which relates various macroeconomic (systematic) risk variables to the pricing of financial assets. Proposed by economist Stephen Ross in 1976,^{[1]} it is widely believed to be an improved alternative to its predecessor, the capital asset pricing model (CAPM).^{[2]} APT is founded upon the law of one price, which suggests that within an equilibrium market, rational investors will implement arbitrage such that the equilibrium price is eventually realised.^{[2]} As such, APT argues that when opportunities for arbitrage are exhausted in a given period, then the expected return of an asset is a linear function of various factors or theoretical market indices, where sensitivities of each factor is represented by a factorspecific beta coefficient or factor loading. Consequently, it provides traders with an indication of ‘true’ asset value and enables exploitation of market discrepancies via arbitrage. The linear factor model structure of the APT is used as the basis for evaluating asset allocation, the performance of managed funds as well as the calculation of cost of capital.^{[3]} Furthermore, the newer APT model is more dynamic being utilised in more theoretical application than the preceding CAPM model. A 1986 article written by Gregory Connor and Robert Korajczyk, utilised the APT framework and applied it to portfolio performance measurement suggesting that the Jensen coefficient is an acceptable measurement of portfolio performance.^{[4]}
Model[edit]
APT is a singleperiod static model, which helps investors understand the tradeoff between risk and return. The average investor aims to optimise the returns for any given level or risk and as such, expects a positive return for bearing greater risk. As per the APT model, risky asset returns are said to follow a factor intensity structure if they can be expressed as:
 where
 is a constant for asset
 is a systematic factor
 is the sensitivity of the th asset to factor , also called factor loading,
 and is the risky asset's idiosyncratic random shock with mean zero.
Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors.
The APT model states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:
 where
 is the risk premium of the factor,
 is the riskfree rate,
That is, the expected return of an asset j is a linear function of the asset's sensitivities to the n factors.
Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be perfect competition in the market, and the total number of factors may never surpass the total number of assets (in order to avoid the problem of matrix singularity).
General Model[edit]
For a set of assets with returns , factor loadings , and factors , a general factor model that is used in APT is:
Assumptions of APT Model[edit]
The APT model for asset valuation is founded on the following assumptions:^{[2]}
 Investors are riskaverse in nature and possess the same expectations
 Efficient markets with limited opportunity for arbitrage
 Perfect capital markets
 Infinite number of assets
 Risk factors are indicative of systematic risks that cannot be diversified away and thus impact all financial assets, to some degree. Thus, these factors must be:
 Nonspecific to any individual firm or industry
 Compensated by the market via a risk premium
 A random variable
Arbitrage[edit]
Arbitrage is the practice whereby investors take advantage of slight variations in asset valuation from its fair price, to generate a profit. It is the realisation of a positive expected return from overvalued or undervalued securities in the inefficient market without any incremental risk and zero additional investments.
Mechanics[edit]
In the APT context, arbitrage consists of trading in two assets – with at least one being mispriced. The arbitrageur sells the asset which is relatively too expensive and uses the proceeds to buy one which is relatively too cheap.
Under the APT, an asset is mispriced if its current price diverges from the price predicted by the model. The asset price today should equal the sum of all future cash flows discounted at the APT rate, where the expected return of the asset is a linear function of various factors, and sensitivity to changes in each factor is represented by a factorspecific beta coefficient.
A correctly priced asset here may be in fact a synthetic asset  a portfolio consisting of other correctly priced assets. This portfolio has the same exposure to each of the macroeconomic factors as the mispriced asset. The arbitrageur creates the portfolio by identifying n correctly priced assets (one per riskfactor, plus one) and then weighting the assets such that portfolio beta per factor is the same as for the mispriced asset.
When the investor is long the asset and short the portfolio (or vice versa) he has created a position which has a positive expected return (the difference between asset return and portfolio return) and which has a net zero exposure to any macroeconomic factor and is therefore risk free (other than for firm specific risk). The arbitrageur is thus in a position to make a riskfree profit:
Where today's price is too low:

Where today's price is too high:

Difference between the capital asset pricing model[edit]
The APT along with the capital asset pricing model (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions, making it more flexible for use in a wider range of application. Thus, it possesses greator explanatory power (as opposed to statistical) for expected asset returns. It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical "market portfolio". In some ways, the CAPM can be considered a "special case" of the APT in that the securities market line represents a singlefactor model of the asset price, where beta is exposed to changes in value of the market.
Fundamentally, the CAPM is derived on the premise that all factors in the economy can be reconciled into one factor represented by a market portfolio, thus implying they all have equivalent weight on the asset’s return. In contrast, the APT model suggests that each stock reacts uniquely to various macroeconomic factors and thus the impact of each must be accounted for separately.^{[2]}
A disadvantage of APT is that the selection and the number of factors to use in the model is ambiguous. Most academics use three to five factors to model returns, but the factors selected have not been empirically robust. In many instances the CAPM, as a model to estimate expected returns, has empirically outperformed the more advanced APT.^{[5]}
Additionally, the APT can be seen as a "supplyside" model, since its beta coefficients reflect the sensitivity of the underlying asset to economic factors. Thus, factor shocks would cause structural changes in assets' expected returns, or in the case of stocks, in firms' profitabilities.
On the other side, the capital asset pricing model is considered a "demand side" model. Its results, although similar to those of the APT, arise from a maximization problem of each investor's utility function, and from the resulting market equilibrium (investors are considered to be the "consumers" of the assets).
Implementation[edit]
As with the CAPM, the factorspecific betas are found via a linear regression of historical security returns on the factor in question. Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors  the number and nature of these factors is likely to change over time and between economies. As a result, this issue is essentially empirical in nature. Several a priori guidelines as to the characteristics required of potential factors are, however, suggested:
 their impact on asset prices manifests in their unexpected movements and they are completely unpredictable to the market at the beginning of each period ^{[2]}
 they should represent undiversifiable influences (these are, clearly, more likely to be macroeconomic rather than firmspecific in nature) on expected returns and so must be quantifiable with nonzero prices ^{[2]}
 timely and accurate information on these variables is required
 the relationship should be theoretically justifiable on economic grounds
Chen, Roll and Ross identified the following macroeconomic factors as significant in explaining security returns:^{[6]}
 surprises in inflation;
 surprises in GNP as indicated by an industrial production index;
 surprises in investor confidence due to changes in default premium in corporate bonds;
 surprise shifts in the yield curve.
As a practical matter, indices or spot or futures market prices may be used in place of macroeconomic factors, which are reported at low frequency (e.g. monthly) and often with significant estimation errors. Market indices are sometimes derived by means of factor analysis. More direct "indices" that might be used are:
 shortterm interest rates;
 the difference in longterm and shortterm interest rates;
 a diversified stock index such as the S&P 500 or NYSE Composite;
 oil prices
 gold or other precious metal prices
 Currency exchange rates
International arbitrage pricing theory[edit]
International arbitrage pricing theory (IAPT) is an important extension of the base idea of arbitrage pricing theory which further considers factors such as exchange rate risk. In 1983 Bruno Solnik created an extension of the original arbitrage pricing theory to include risk related to international exchange rates hence making the model applicable international markets with multicurrency transactions. Solnik suggested that there may be several factors common to all international assets, and conversely, there may be other common factors applicable to certain markets based on nationality.^{[7]}
Fama and French originally proposed a threefactor model in 1995 which, consistent with the suggestion from Solnik above suggests that integrated international markets may experience a common set of factors, hence making it possible to price assets in all integrated markets using their model. The Fama and French three factor model attempts to explain stock returns based on market risk, size, and value.^{[8]}
A 2012 paper aimed to empirically investigate Solnik’s IAPT model and the suggestion that base currency fluctuations have a direct and comprehendible effect on the risk premiums of assets. This was tested by generating a returns relation which broke down individual investor returns into currency and noncurrency (universal) returns. The paper utilised Fama and French’s three factor model (explained above) to estimate international currency impacts on common factors. It was concluded that the total foreign exchange risk in international markets consisted of the immediate exchange rate risk and the residual market factors. This, along with empirical data tests validates the idea that foreign currency fluctuations have a direct effect on risk premiums and the factor loadings included in the APT model, hence, confirming the validity of the IAPT model.^{[9]}
See also[edit]
 Beta coefficient
 Capital asset pricing model
 Carhart fourfactor model
 Cost of capital
 Earnings response coefficient
 Efficientmarket hypothesis
 Fama–French threefactor model
 Fundamental theorem of arbitragefree pricing
 Investment theory
 Modern portfolio theory
 Postmodern portfolio theory
 Rational pricing
 Risk factor (finance)
 Roll's critique
 Value investing
References[edit]
 ^ Ross, Stephen A (19761201). "The arbitrage theory of capital asset pricing". Journal of Economic Theory. 13 (3): 341–360. doi:10.1016/00220531(76)900466. ISSN 00220531.
 ^ ^{a} ^{b} ^{c} ^{d} ^{e} ^{f} Basu, Debarati; Chawla, Deepak (2012). "An Empirical Test of the Arbitrage Pricing Theory—The Case of Indian Stock Market". Global Business Review. 13 (3): 421–432. doi:10.1177/097215091201300305. ISSN 09721509. S2CID 154470693.
 ^ Huberman, G. & Wang, Z. (2005). "Arbitrage Pricing Theory" (PDF).
{{cite web}}
: CS1 maint: multiple names: authors list (link)  ^ Connor, Gregory; Korajczyk, Robert (1986). "Performance measurement with the arbitrage pricing theory: A new framework for analysis". Journal of Financial Economics. 15 (3): 373–394. doi:10.1016/0304405X(86)900279. S2CID 54620410.
 ^ French, Jordan (1 March 2017). "Macroeconomic Forces and Arbitrage Pricing Theory". Journal of Comparative Asian Development. 16 (1): 1–20. doi:10.1080/15339114.2017.1297245. S2CID 157510462.
 ^ Chen, NaiFu; Roll, Richard; Ross, Stephen A. (1986). "Economic Forces and the Stock Market". The Journal of Business. 59 (3): 383–403. doi:10.1086/296344. ISSN 00219398. JSTOR 2352710.
 ^ Solnik, Bruno (1983). "International Arbitrage Pricing Theory". The Journal of Finance. 38 (2): 449–457. doi:10.2307/2327978. JSTOR 2327978.
 ^ Fama, Eugene; French, Kenneth (1996). "Multifactor Explanations of Asset Pricing Anomalies". The Journal of Finance. 51 (1): 55–84. doi:10.1111/j.15406261.1996.tb05202.x.
 ^ Armstrong, Will; Knif, Johan; Kolari, James; Pynnonen, Seppo (2012). "Exchange risk and universal returns:A test of international arbitrage pricing theory". Pacific Basin Finance Journal. 20 (1): 24–40. doi:10.1016/j.pacfin.2011.08.003.
Further reading[edit]
 Burmeister, Edwin; Wall, Kent D. (1986). "The arbitrage pricing theory and macroeconomic factor measures". Financial Review. 21 (1): 1–20. doi:10.1111/j.15406288.1986.tb01103.x.
 Chen, N. F.; Ingersoll, E. (1983). "Exact Pricing in Linear Factor Models with Finitely Many Assets: A Note". Journal of Finance. 38 (3): 985–988. doi:10.2307/2328092. JSTOR 2328092.
 Roll, Richard; Ross, Stephen (1980). "An empirical investigation of the arbitrage pricing theory". Journal of Finance. 35 (5): 1073–1103. doi:10.2307/2327087. JSTOR 2327087.
External links[edit]
 The Arbitrage Pricing Theory Prof. William N. Goetzmann, Yale School of Management
 The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning (PDF), Richard Roll and Stephen A. Ross
 The APT, Prof. Tyler Shumway, University of Michigan Business School
 The arbitrage pricing theory Investment Analysts Society of South Africa
 References on the Arbitrage Pricing Theory, Prof. Robert A. Korajczyk, Kellogg School of Management
 Chapter 12: Arbitrage Pricing Theory (APT), Prof. Jiang Wang, Massachusetts Institute of Technology.