Arbitrage Pricing Theory (APT)

A model of financial instrument and portfolio behavior based on the proposition that if the returns of a portfolio of assets can be described by a factor structure or model, the expected return of each asset in the portfolio can be described by a linear combination of the factors with the returns of the asset. The factors can be statistical artifacts; they can be market or industry related; or they can be macroeconomic variables such as interest rates, inflation, industrial production, etc. The resulting factor model can be used to create portfolios that track a market index, to estimate and monitor the risk of an asset allocation strategy, or to estimate the likely response of a portfolio to economic developments. Starting from an initial model proposed by Stephen Ross, APT models have been created for applications in most cash and derivatives markets. See Multi- Factor Model.

Glossary * A