Brief Definition
Arbitrage Pricing Theory (APT) is a financial model that helps determine the expected return of an investment based on different factors that affect its risk. It takes into account multiple factors, like interest rates and inflation, instead of just the overall market risk. The theory assumes that investors will adjust prices to ensure fair value. Essentially, APT provides a way to analyze and price investments by considering various factors that can impact their returns.
Further Explanation
Arbitrage Pricing Theory (APT) is a financial model that helps explain the relationship between the expected return of an investment and its associated risk. APT suggests that an investment’s return is influenced by multiple factors or “risk factors” rather than just the overall market risk (as in the Capital Asset Pricing Model). These risk factors can include interest rates, inflation, exchange rates, and other economic variables.
According to APT, the expected return of an investment can be determined by the sensitivity of its returns to these underlying risk factors. The theory assumes that investors will engage in arbitrage, which is the practice of taking advantage of price differences between markets, to ensure that investments are fairly priced.
In simpler terms, APT suggests that the return of an investment is influenced by various factors beyond the overall market risk. By considering these additional risk factors, the theory provides a framework for understanding and pricing investments in a more comprehensive way.