Arbitrage Pricing Theory (APT) is a financial model that predicts asset returns using multiple economic factors. Developed by Stephen Ross in 1976, APT challenges the Capital Asset Pricing Model (CAPM) by considering various systematic risk factors. It assumes that unsystematic risk is diversifiable and that markets are perfectly competitive. APT is crucial for portfolio management, risk management, and strategic asset allocation, despite its practical challenges.
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APT is a financial model that predicts the expected return on an asset by considering various economic factors
Differences between APT and CAPM
APT differs from CAPM by incorporating multiple risk factors instead of relying solely on a market portfolio
APT assumes that investors can diversify away unsystematic risk, there are no transaction costs, and capital can be borrowed or lent at a risk-free rate without restrictions
The APT equation includes the expected return on the asset, the risk-free rate, the asset's sensitivity to risk factors, the expected risk premium of the factors, and the asset-specific risk
The APT equation allows for the assessment of securities by evaluating their exposure to various systematic risk factors and the corresponding premiums associated with those risks
APT assumes that arbitrage opportunities are non-existent, asset returns are generated by a factor model, unsystematic risk can be fully diversified away, and the markets are perfectly competitive
Applications of APT in portfolio management
APT is used in portfolio management for risk management, pursuit of higher returns, and strategic asset allocation
Applications of APT in corporate finance
APT is used in corporate finance for performance benchmarking, derivative pricing, and strategic decision-making
APT is a multifactorial approach that considers various economic factors, while CAPM is a single-factor model that focuses on market risk
APT does not require assumptions of market efficiency and homogeneous investor expectations, while CAPM is built on these assumptions
A thorough understanding of both APT and CAPM is essential for financial proficiency and informed investment decision-making
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APT vs. CAPM: Key Differences
APT uses multiple risk factors for asset return predictions; CAPM relies on market portfolio's single factor.
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Systematic Risk Factors in APT
APT identifies several economic forces that affect asset returns, unlike CAPM's single market risk.
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Assumptions Underlying APT
APT assumes investors can eliminate unsystematic risk, no transaction costs, and unrestricted borrowing/lending at risk-free rate.
