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APT

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The term APT generally refers to the arbitrage pricing theory. Much like the capital asset pricing model, the APT is able to discount the future cash flows of an asset, and in turn price the asset. The APT accomplishes this by looking at how the asset reacts to changes in certain exogenous factors. Whereas the CAPM looks primarily at the factor sensitivity of the asset's beta, the APT incorporates any number of factors that influence the price of the asset. In practice many of the factor sensitivities used in the APT come from a strictly macroeconomic background, which are often calculated by performing a multivariate regression. The expected return from each factor is then combined with each asset's factor sensitivity in order to determine the expected return under the APT. The notion of arbitrage is brought into the APT when an asset is priced such that its expected return is different than what is predicted by the APT. If the actual expected return of the asset is higher than the model predicts then the APT suggests that someone will sell the market portfolio and buy the incorrectly priced asset in order to create risk free profits. In this manner, APT suggests that arbitrage will eventually cause all prices to converge to the price that is suggested by the APT model.



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