Developed by economist Stephen Ross in 1976, arbitrage pricing theory is a general theory of asset pricing which contends that a relationship between the returns of a portfolio and the returns of a single asset may be charted through a linear combination of many independent macro-economic variables. These macro-economic variables are called as risk factors. In other words, the arbitrage pricing theory asserts that if two or more securities or portfolios have identical return and risk, then they should sell for one price. Since, the arbitrage pricing theory (model) gives the expected price of an asset, arbitrageurs use APT to identify and take advantage from mispriced securities.
APT gives the expected return on asset i as:
E(Ri) = Rf + b1*(E(R1) - Rf) + b2*(E(R2) - Rf) + b3*(E(R3) - Rf) + …+ bn*(E(Rn) - Rf)
Rf = Risk free interest rate (i.e. interest on Treasury Bonds)
bi = Sensitivity of the asset to factori
E(Ri) - Rf) = Risk premium associated with factori where i = 1, 2,...n
Few factors that tend to influence the price of the security are
a.) Change in GDP or industrial production
b.) Surprises in inflation (or deflation)
c.) Shifts in the Yield Curve.
APT seeks to overcome the weaknesses of Capital Asset Pricing Model as it uses fewer assumptions. While the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors.