Arbitrage Pricing Theory (APT)

The Arbitrage Pricing Theory (APT) is a financial theory that explains the relationship between systematic risk and expected return. It is a general equilibrium model that assumes that all investors are rational and have the same information. The APT also assumes that investors can trade freely and without transaction costs.

The APT states that the expected return on an asset is a linear function of its sensitivity to the market portfolio. The market portfolio is a hypothetical portfolio that includes all assets in the market, and it is assumed to be efficient. The sensitivity of an asset to the market portfolio is called its beta.

The APT can be used to estimate the expected return on an asset. To do this, you need to know the asset's beta and the expected return on the market portfolio. The expected return on the market portfolio is often estimated using the Capital Asset Pricing Model (CAPM).

The APT is a more general theory than the CAPM. The CAPM only applies to the case where there is one factor that drives returns. The APT allows for multiple factors to drive returns.

The APT has been criticized for being too complex and for not being able to be tested empirically. However, the APT remains an important financial theory because it provides a framework for understanding the relationship between risk and return.

The APT has been used to explain a variety of financial phenomena, including the size effect, the value effect, and the momentum effect. The APT has also been used to develop investment strategies.

The APT is a valuable tool for understanding the relationship between risk and return. However, it is important to remember that the APT is a theoretical model, and it may not always be accurate in practice.