Arbitrage Pricing Theory
Arbitrage Pricing Theory was developed by Stephen
Ross (1976).
His theory begins with an analysis of how investors
construct efficient portfolios.
This theory offers a new approach for explaining the
asset prices and states that the return on any risky asset
is a linear combination of various macroeconomic
factors that are not explained by this theory.
Similar to CAPM it assumes that investors are fully
diversified and the systematic risk is an influencing
factor in the long run.
However, unlike CAPM model APT specifies a simple
linear relationship between asset returns and the
associated factors because each share or portfolio may
have a different set of risk factors and a different degree
of sensitivity to each of them.
Assumptions
Capital markets are perfectly
competitive.
Investors always prefer more wealth
to less wealth with certainty.
The random probability distribution
process generating asset returns can
be expressed as a linear function of a
set of K factors or indexes.
Factors that effect APT
Multiple factors expected to have an impact on all
assets:
– Inflation
– Growth in GNP
– Major political upheavals
– Changes in interest rates
Contrast with CAPM insistence that only beta is
relevant.
APT assumes that, in equilibrium, the return on a
zero-investment, zero-systematic-risk portfolio is
zero when the unique effects are diversified
away.
