The Arbitrage Pricing Theory – APT is a theoretical multi-factor model based on the same principle as the capital asset pricing model – CAPM but expand the number of risk factors:
E(Rp) = RF + λ1βp,1 + … + λK βp,K
where
E(Rp) = the expected return of portfolio p
RF = the risk-free rate
λj = the risk premium (expected return in excess of the risk-free rate) for factor j
βp,j = the sensitivity of the portfolio to factor j
K = the number of risk factors
Other than the risk-free rate, the various risk factors may vary from one asset to another. A no-arbitrage condition in asset markets is used to determine the risk factors and estimate betas for the risk factors.
Although it is theoretically elegant, flexible, and superior to the CAPM, APT is not commonly used in practice because it does not specify any of the risk factors and it becomes difficult to identify risk factors and estimate betas for each asset in a portfolio. So, from a practical standpoint, the CAPM is preferred to APT.
A more comprehensive content for the concept will be available later.
We will include related examples and CFA questions that are also hyperlinked to the appropriate definitions.