Arbitrage Pricing Theory (APT) is used to assess and anticipate the returns of assets and portfolios.
APT is a model that shows the relationship between an asset’s expected risk and the return.
The APT model shows how the changes in macroeconomic factors affect an asset’s returns. These variables are inflation, interest rates, exchange rates, etc.
APT is an alternative model to the Capital Asset Pricing Model (CAPM). Although, both the theories represent the relationship between risk and expected risk, the arbitrage pricing theory is harder to gauge and implement
Arbitrage is the process of buying an asset at a lower price and then selling it at a higher price. In theory, arbitrage offers the investors a high chance of success.
The return on assets is calculated by taking into consideration the systematic risks such as risk premiums, changes in inflation, interest rates, etc. Investors usually construct their portfolios with unsystematic risks, that are well-diversified to bring the total portfolio risk down.
There is no opportunity for the investors to engage in arbitrage with the diversification of portfolios. Arbitrage is used by the realization of the differences between the expected and real returns. If there is an opportunity, it would be exploited by the investors.
When the prices of the securities in the market are not efficient, APT brings out a fair price to the market.
Missed priced security (MPS) allows arbitrageurs to also make some gains from it.
The APT shows that the returns on assets and ROI follow a linear pattern. An investor can deviate from the linear path using the arbitrage strategy. Arbitrage is a process of the simultaneous buying and sale of an asset on different exchanges, to gain from the small pricing premium to lock in a risk-free profit for the trade. However, the APT’s idea of arbitrage is actually different from the classic meaning. In the APT, arbitrage is not risk-free – but it offers a high probability of success.
The arbitrage pricing theory provides the traders a model for finding out the theoretical fair market value of an asset. Once the value is derived, traders can then look for small deviations from the fair market price and trade in that manner.
Arbitrage Pricing Theory deals with a pricing model that takes many sources of risk and uncertainty into account. Unlike the CAPM, which only takes into account the risk level of the overall market, the APT model judges several macroeconomic factors that determine the risk and return of the particular asset. These factors offer the risk premiums for investors to check as the factors carry a systematic risk that cannot be removed by diversification.
The APT suggests that investors will necessarily diversify their portfolios, but they will also collect their own individual risk and returns depending on the sensitivity and premiums of the macroeconomic risk factors. Risktaking investors will usually exploit the differences in anticipated and real returns on the asset by utilizing arbitrage.