Arbitrage Pricing Theory

Arbitrage Pricing Theory or APT |

As its name implies, the Arbitrage Pricing Theory, or APT, describes a mechanism used by investors to identify an asset, such as a share of common stock, which is incorrectly priced. Investors can subsequently bring the price of the security back into alignment with its actual value.The Arbitrage Pricing Theory ModelThe APT model was first described by Steven Ross in an article entitled The Arbitrage Theory of Capital Asset Pricing, which appeared in the Journal of Economic Theory in December 1976. The Arbitrage Pricing Theory assumes that each stock's (or asset's) return to the investor is influenced by several independent factors.The APT Formula Additional Resources |

* Stock Research Part I * Calculating Stock Prices * Capital Asset Pricing Model * Arbitrage Pricing Theory * Stock Beta and Volatility * Reading a Value Line Report * Understanding Price Momentum * Random Walk Theory Explained |

Furthermore, Ross stated the return on a stock must follow a very simple relationship that is described by the following formula:Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n)Where: * rf = the risk free interest rate, which is the interest rate the investor would expect to receive from a risk-free investment. Typically, U.S. Treasury Bills are used for U.S. dollar calculations, while German Government bills are used for the Euro * b = the sensitivity of the stock or security to each factor * factor = the risk premium associated with each entityThe APT model also states the risk premium of a stock depends on two factors: * The risk premiums associated with each of the factors described above * The stock's own sensitivity to each of the factors; similar to the beta conceptRisk Premium = r - rf = b(1) x (r factor(1) - rf) + b(2) x (r factor(2) - rf)... + b(n) x (r factor(n) - rf)If the expected risk premium on a stock were lower than the calculated risk premium using the formula...