11/22/2014

ArbitragePricingTheory(APT)Definition&Example|InvestingAnswers

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ArbitragePricingTheory(APT)
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Whatitis:
Arbitragepricingtheory(APT)isawellknownmethodofestimatingthepriceofanasset.The
theoryassumesanasset'sreturnisdependentonvariousmacroeconomic,marketandsecurity
specificfactors.
Howitworks/Example:
APTisanalternativetothecapitalassetpricingmodel(CAPM).StephenRossdevelopedthetheoryin
1976.
TheAPTformulais:

RelatedTerms

E(rj)=rf+bj1RP1+bj2RP2+bj3RP3+bj4RP4+...+bjnRPn

Benchmark

where:
E(rj)=theasset'sexpectedrateofreturn
rf=theriskfreerate
bj=thesensitivityoftheasset'sreturntotheparticularfactor
RP=theriskpremiumassociatedwiththeparticularfactor
ThegeneralideabehindAPTisthattwothingscanexplaintheexpectedreturnonafinancialasset:1)
macroeconomic/securityspecificinfluencesand2)theasset'ssensitivitytothoseinfluences.This
relationshiptakestheformofthelinearregressionformulaabove.

ViewAll

NetProfitMargin
PriceMultiple
BookValue
DeferredRevenue
DividendYield
VariableCosts

Thereareaninfinitenumberofsecurityspecificinfluencesforanygivensecurityincludinginflation,
productionmeasures,investorconfidence,exchangerates,marketindicesorchangesininterest
rates.Itisuptotheanalysttodecidewhichinfluencesarerelevanttotheassetbeinganalyzed.
Oncetheanalystderivestheasset'sexpectedrateofreturnfromtheAPTmodel,heorshecan
determinewhatthe"correct"priceoftheassetshouldbebypluggingtherateintoadiscountedcash
flowmodel.
NotethatAPTcanbeappliedtoportfoliosaswellasindividualsecurities.Afterall,aportfoliocanhave
exposuresandsensitivitiestocertainkindsofriskfactorsaswell.
WhyitMatters:
TheAPTwasarevolutionarymodelbecauseitallowstheusertoadaptthemodeltothesecuritybeing
analyzed.Andaswithotherpricingmodels,ithelpstheuserdecidewhetherasecurityisundervalued
orovervaluedandsoheorshecanprofitfromthisinformation.APTisalsoveryusefulforbuilding
portfoliosbecauseitallowsmanagerstotestwhethertheirportfoliosareexposedtocertainfactors.
APTmaybemorecustomizablethanCAPM,butitisalsomoredifficulttoapplybecausedetermining
whichfactorsinfluenceastockorportfoliotakesaconsiderableamountofresearch.Itcanbevirtually
impossibletodetecteveryinfluentialfactormuchlessdeterminehowsensitivethesecurityistoa
particularfactor.Butgetting"closeenough"isoftengoodenoughinfactstudiesfindthatfourorfive
factorswillusuallyexplainmostofasecurity'sreturn:surprisesininflation,GNP,investorconfidence
andshiftsintheyieldcurve.

TermoftheDay

BestExecution
Bestexecutionreferstotheimperativethata
broker,marketmaker,orotheragentactingon
behalfofaninvestorisobligatedtoexecutethe
investor'sorderinawaythatismost
advantageoustotheinvestorratherthanthe
agent.
Continuereading...

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11/22/2014

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