Arbitrage pricing theory (APT)

Definition

Arbitrage pricing theory (APT) in plain English

Arbitrage Pricing Theory (APT) is a recipe for figuring out what return an investment SHOULD offer, based on how sensitive it is to a handful of big economy-wide forces — things like inflation, interest rates, or overall growth. The idea: some risks (a factory fire) can be diversified away by owning many stocks, but shared risks that hit everything at once cannot, so investors demand extra reward for taking them on. Think of it like predicting how bumpy a car ride will be by adding up how much it reacts to each type of road hazard — potholes, wind, hills — weighted by how rough each hazard is. 'No-arbitrage' is the anchor: prices must line up so there's no free-lunch opportunity, and that logic pins down the fair return.

Related Principles of Finance terms

• Agency bond
• American option
• Asset-backed security (ABS)
• Basis risk
• Bid-ask spread
• Bookrunner
• Carhart four-factor model
• Clientele effect
• Collateralized debt obligation (CDO)
• Common-size analysis