APT (Arbitrage Pricing Theory)
Quantitative Finance glossary · Derivatives Pricing & Volatility Surfaces
Definition
Ross's multi-factor model derived purely from no-arbitrage (no utility assumption, unlike CAPM): E[R_i] = r_f + sum_k=1^K β_i,k,λ_k, where β_i,k is asset i's loading on factor k and λ_k is that factor's risk premium. Unlike CAPM, APT is silent on what the factors are — practitioners use macroeconomic factors (Chen-Roll-Ross: industrial production, inflation surprise, term spread, credit spread) or statistical factors from PCA. Fama-French and Carhart are operationalisations.
APT (Arbitrage Pricing Theory) in plain English
APT says an asset's expected return is just a sum of its exposures to a handful of underlying forces, each carrying its own reward for the risk it brings. The clever part is how it's justified: instead of assuming anything about how people feel about risk, it only assumes you can't get free money for nothing, so prices must line up sensibly. Think of a smoothie's price as built up from its ingredients — a bit for the strawberries, a bit for the mango — where here the 'ingredients' are things like inflation surprises or the gap between risky and safe bond rates. Its honesty is also its weakness: the theory refuses to tell you which forces matter, so practitioners have to pick them themselves, which is exactly what famous factor models do.
Also called: Arbitrage Pricing Theory
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