Introduction

In the realm of modern finance, understanding theories that underpin the assessment of risk and return is essential. One such theory is the Arbitrage Pricing Theory (APT), a multifactor model that provides an alternative approach to the Capital Asset Pricing Model (CAPM) in determining asset prices and expected returns. In this chapter, we will delve into the depths of APT, its assumptions, and a comparative analysis with CAPM. Through this exploration, we aim to shed light on the unique attributes and applications of APT in the context of risk and return assessment.

Arbitrage Pricing Theory (APT)

The Arbitrage Pricing Theory (APT) is a multifactor model designed to explain the relationship between asset prices and various macroeconomic factors. APT was introduced as an alternative to CAPM, providing a more flexible framework that accommodates multiple factors affecting asset returns. APT asserts that an asset’s expected return is influenced by several systematic factors, and arbitrage opportunities ensure that assets are correctly priced in equilibrium.

Assumptions of APT

APT is built on several key assumptions that provide the foundation for its application:

• No Arbitrage: A fundamental assumption is the absence of arbitrage opportunities. In other words, it assumes that there are no riskless opportunities for profit without taking on risk.

• Factor Structure: APT assumes that asset returns are driven by a set of underlying macroeconomic factors. These factors are not specified by the theory but can include variables like interest rates, inflation, GDP growth, etc.

• Factor Sensitivity: Each asset’s returns are sensitive to changes in these macroeconomic factors, with unique factor sensitivities (betas) that determine the asset’s risk exposure.

APT Vs CAPM

While both APT and CAPM are used to estimate expected returns, they differ in their approach and assumptions. CAPM relies on the systematic risk (beta) of an asset in relation to the market, assuming that a single factor (market risk) drives asset returns. APT, on the other hand, considers multiple factors, acknowledging that a diverse set of factors affects asset prices. This makes APT more flexible in accommodating various sources of risk and return, making it better suited for real-world scenarios where one factor may not adequately capture all sources of risk.