What is ARBITRAGE PRICING THEORY (APT)?

A financial theory posited as a testable, and more flexible, alternative to the CAPITAL ASSET PRICING MODEL (CAPM), based on the concept that multiple linear RISK factors influence the return of a security, and the factors can be estimated through principal components/factor analysis. By understanding the risk and return contribution of each factor, an optimal portfolio can be created. APT, like CAPM, makes use of BETA as a measure of risk. The singlefactor APT return is given by: where E(rj) is the expected return of security j, E(rf) is the expected RISKFREE RATE, 1 is the slope of risk factor 1, and 1 is the beta related to risk factor 1 and security j. The equation can be expanded to multifactor form, with z risk factors: Additional references: Roll (1977), Roll and Ross (1980), Ross (1976).

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