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Arbitrage Pricing Theory

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Arbitrage pricing theory (APT) posits that investors can predict the return on an asset by tracking its performance in relationship with independent macro-economic variables and common risk factors. Variables and risk factors referenced in arbitrage pricing theory models might include GDP, inflation, interest rates, yield spreads, etc. Arbitrage pricing theory presumes the asset being tracked is sensitive to these variables and risk factors and that the relationship is linear. As in any form of arbitrage, users of arbitrage pricing theory are trying to take advantage of imbalances in a market or between two or more markets. Stock investors use arbitrage pricing theory to identify stocks that are mispriced, then short stocks that are too high and buy stocks that are too low. Arbitrage pricing theory is an alternative to the capital asset pricing model (CAPM). CAPM is much simpler than arbitrage pricing theory because it relies on only two factors -- a stock's beta and the stock market's risk premium. CAPM investors commonly hold high beta stocks in a rising market and low beta stocks in a falling market. Stephen Ross first modeled arbitrage pricing theory in 1976.

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