What is Arbitrage Pricing Theory (APT)? Meaning and Definition

Meaning of Arbitrage Pricing Theory (APT) is one of the tools used by investors and portfolio managers who explain the return of severity based on their respective beta. This theory was developed by Stephen Ross. In finance, the APT is a general theory of property pricing that believes that the expected return of financial assets can model as a linear function of various factors or theoretical market index, wherein each of the factors The sensitivity of change is represented by a factor-specific beta coefficient. So, what is the question; What is Arbitrage Pricing Theory (APT)? Meaning and Definition.

Here are explains What is Arbitrage Pricing Theory (APT)? with Meaning and Definition.

APT is a multi-factor property pricing model based on the idea that calculating asset returns can be done using linear relationships between the expected return of assets and many macroeconomic variables that hold systematic risk. Also, This theory was created in 1976 by economist Stephen Ross. The arbitrage pricing principle provides a multi-factor pricing model for securities based on the relation between the expected return of financial assets and their risk to analysts and investors. This is a useful tool to analyze the portfolio from a price investment perspective, to temporarily identify the securities incorrectly.

APT is a more flexible and complicated option for the Capital Asset Pricing Model (CAPM). The theory provides investors and analysts with the opportunity to customize their research. As well, the model-derived rate of return will use to correctly assess the property; Also, the asset value should be equal to the expected end of the discount period at the rate mentioned by the model. If the price goes away, then arbitrage will bring it back to the line.

What does mean the Arbitrage Pricing Theory (APT)?

Arbitrage Pricing Theory (APT) is an extension of CAPM. The pricing model given by APT is the same as CAPM. It is a model under equilibrium. The difference is that APT is based on a multi-factor model. Also, the Arbitrage pricing theory holds that arbitrage behavior is a decisive factor in the formation of modern efficient markets (that is, market equilibrium prices).

If the market does not reach equilibrium, there will be risk-free arbitrage opportunities in the market. And multiple factors uses to explain the return of risk assets, and according to the principle of no-arbitrage; there is an (approximate) linear relationship between the balanced return of risk assets and multiple factors. Also, The previous CAPM model predicts that there is a linear relationship between the returns of all securities; and, the return of a unique public factor (market portfolio).

Significance of Arbitrage Pricing Theory (APT):

Arbitrage pricing theory derives a market relationship similar to the capital asset pricing model. The arbitrage pricing theory base on the multi-factor model of the rate of the return formation process. Also, It believes that the rate of return of securities linearly relates to a set of factors; which represent some basic factors of the rate of return of securities.

When the rate of return form by a single factor (market combination), you will find that the arbitrage pricing theory forms a relationship with the capital asset pricing model. Therefore, the arbitrage pricing theory can consider as a generalized capital asset pricing model, providing investors with an alternative method to understand the equilibrium relationship between risk and return in the market. Also, Arbitrage pricing theory and modern asset portfolio theory, capital asset pricing model, option pricing model, etc. constitute the theoretical basis of modern finance.

Difference between APT and CAPM:

In 1976, American scholar Stephen Rose published the classic paper "Arbitrage Theory of Capital Asset Pricing" in the Journal of Economic Theory; and, proposed a new asset pricing model, which is the arbitrage pricing theory (APT theory). Also, Arbitrage pricing theory uses the concept of arbitrage to define equilibrium, does not require the existence of market portfolios, and requires fewer assumptions than the capital asset pricing model (CAPM model), and more reasonable.

Like the capital asset pricing model, the arbitrage pricing theory assumes:

• Investors have the same investment philosophy;
• The investor is unsatisfied and wants to maximize utility;
• Also, The market is complete.

Unlike the capital asset pricing model, arbitrage pricing theory does not have the following assumptions:

• Single investment period;
• There is no tax;
• Also, Investors can borrow freely at a risk-free rate;
• Investors choose investment portfolios based on the mean and variance of returns.

The relationship between the arbitrage pricing theory and capital asset pricing model:

• Both assume that there are no transaction costs or transaction taxes in the capital market; or both believe that if there are transaction costs or transaction taxes, they are the same for all investors.
• Both of them divide the existing risks into systemic and non-systemic risks, that is, market risk and the company's own risk. Moreover, both models believe that through the diversified portfolio of investments and the rational optimization of the investment structure by investors; the company ’s risks can be largely or even eliminated. Therefore, when calculating the expected return of the investment portfolio; the mathematical expressions of both models believe that the capital market will not compensate investors; because, they have assumed this part of the risk, so they not include in the calculation.
• Capital asset pricing theory can regard as a special case of arbitrage pricing theory under stricter assumptions.

The role of the arbitrage pricing theory and capital asset pricing model:

The proposal of CAPM and APT has had a huge impact on financial theory research and practice all over the world. Its main performances are:

• Most institutional investors evaluate their investment performance according to the relationship between expected return and β coefficient (or unit risk-reward);
• The regulatory authorities of most countries take the relationship between the expected rate of return; and, the β coefficient together with the prediction of the market index rate of return as an important factor when determining the capital cost of the regulated object;
• The court often uses the relationship between the expected rate of return and β coefficient to determine the discount rate when measuring the amount of compensation for future loss of income
• Many companies also use the relationship between the expected rate of return and the β coefficient to determine the minimum required rate of return when making capital budget decisions. As well as it can see that the combination of the two can make more accurate predictions than pure APT; and, can make more extensive analysis than CAPM, to provide more adequate guidance for investment decisions.