## Arbitrage Pricing Theory (APT)

A substitute and concurrent theory to the Capital Asset Pricing Model (CAPM) is one that incorporates multiple factors in explaining the movement of asset prices. The arbitrage pricing model (APT) on the other hand approaches pricing from a different aspect. It is rarely successful to analyse portfolio risks by assessing the weighted sum of its components. Equity portfolios are far more diverse and enormously large for separate component assessment, and the correlation existing between the elements would make a calculation as such untrue. Rather, the portfolio’s risk should be viewed as a single product’s innate risk. The APT represents portfolio risk by a factor model that is linear, where returns are a sum of risk factor returns. Factors may range from macroeconomic to fundamental market indices weighted by sensitivities to changes in each factor. These sensitivities are called factor-specific beta coefficients or more commonly, factor loadings. In addition, the firm-specific or idiosyncratic return is added as a noise factor. This last part, as is the case with all econometric models, is indispensable in explaining whatever the original factors failed to include. In contrast with the CAPM, this is not an equilibrium model; it is not concerned with the efficient portfolio of the investor. Rather, the APT model calculates asset pricing using the different factors and assumes that in the case market pricing deviates from the price suggested by the model, arbitrageurs will make use of the imbalance and veer pricing back to equilibrium levels. At its simplest form, the arbitrage pricing model can have one factor only, the market portfolio factor. … Read the rest