Arbitrage pricing theory
What is arbitrage pricing theory (APT)?
This is a way of estimating the price of an asset. It’s based on the idea that returns can be predicted if you look at a number of common risk factors.
Where have you heard of APT?
It’s often seen as an alternative to the capital asset pricing model (CAPM). It can be applied to portfolios as well as individual securities, so it’s a well-known method of estimating prices.
What you need to know about APT…
It was first developed in 1976, based on the idea that an expected return can be predicted by looking at a number of macroeconomic variables and the asset’s sensitivity to these factors. Variables considered could include interest rates and inflation. Unlike CAPM, APT does not require you to know the market’s expected return. Once you’ve worked out the asset’s expected rate of return, you can then determine what its “correct” price should be. This enables users to spot whether a security is under or overvalued, which can help them make money.