Arbitrage pricing theory
A model in which expected return is the risk-free rate plus a premium for each of several factor sensitivities, derived from the absence of arbitrage. Unlike the CAPM, it does not name the factors.
Where you will meet it
Arbitrage pricing theory appears in 3 learning outcomes on the CFA syllabus. A few of them:
- Explain multi-factor models and arbitrage pricing theory as used for equities
“Arbitrage pricing theory generalises the CAPM: expected return is the risk-free rate plus the sum of each factor sensitivity multiplied by that factor's risk premium, E(R) = Rf + b1 x RP1 + b2 x RP2 and so on.”
- Explain arbitrage pricing theory (APT), the assumptions it rests on, and how it connects to multifactor models
“Arbitrage pricing theory says an asset's expected return is linear in its sensitivities to a set of systematic factors: r = risk-free rate + the sum of each factor sensitivity times that factor's risk premium.”
- Say what an arbitrage opportunity is and judge whether one is present
“Under APT, well-diversified portfolios with the same factor sensitivities must offer the same expected return; if they do not, buy the one with the higher expected return and short the other in amounts that match exposures.”
See also
Practise it
Practise arbitrage pricing theory until it is automatic: questions that explain every wrong option.
Take the free diagnostic →