Arbitrage Pricing Theory (APT) is a financial model that describes the relationship between the expected return of an asset and its risk factors. Unlike the Capital Asset Pricing Model (CAPM), which relies on a single market factor, APT considers multiple factors that might influence asset returns. The fundamental premise of APT is that if a security is mispriced due to various influences, arbitrageurs will buy undervalued assets and sell overvalued ones until prices converge to their fair values.
The formula for expected return in APT can be expressed as:
where:
In summary, APT provides a framework for understanding how multiple economic factors can impact asset prices and returns, making it a versatile tool for investors seeking to identify arbitrage opportunities.
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