The arbitrage pricing theory, or APT, is a model of pricing that is based on the concept that an asset can have its returns predicted. To do so, the relationship between the asset and its common risk factors must be analyzed.
APT was first created by Stephen Ross in 1976 to examine the influence of macroeconomic factors. That allows for the returns of a portfolio and the returns of specific asset to be predicted by examining the various variables that are independent within the relationship.
It is based on the idea that in a well-functioning securities market, there should be no arbitrage opportunities available. That makes it possible to predict the outcome of that security over time.
Here are the advantages and disadvantages found when using the arbitrage pricing theory.
List of the Advantages of Arbitrage Pricing Theory
1. It has fewer restrictions.
The APT does not have the same requirements about individual portfolios as other predictive theories. It also has fewer restrictions regarding the types of information allowed to perform predictions. Because there is more information available, with fewer overall restrictions, the results tend to be more reliable with the arbitrage pricing theory than with competitive models.
2. It allows for more sources of risk.
The APT allows for multiple risk factors to be included within the data set being examined instead of excluding them. This makes it possible for individual investors to see more information about why certain stock returns are moving in specific ways. It eliminates many of the questions on movement that other theories leave behind because there are more sources of risks included within the data set.
3. It does not specify specific factors.
Although APT does not offer specific factors like other pricing models, there are four important factors that are taken into account by the theory. APT looks at changes in inflation, changes in industrial production, shifts in risk premiums, and shifts in the structure of interest rates when creating long-term predictive factors.
4. It allows for unanticipated changes.
APT is based on the idea that no surprises are going to happen. That is an unrealistic expectation, so Ross included an equation to support the presence of an unanticipated change. That makes it easier for investors to identify assets which have the strongest potential for growth or the strongest potential for failure, based on the information that is provided by the opportunity itself.
5. It allows investors to find arbitrage opportunities.
The goal of APT is to help investors find securities in the market that are mispriced in some way. Once these can be identified, it becomes possible to build a portfolio based on them to generate returns that are better than what the indexes are offering. If a portfolio is then undervalued, the opportunities can be exploited to generate profits because of the changes in the pricing theory.
List of the Disadvantages of Arbitrage Pricing Theory
1. It generates a large amount of data.
For someone unfamiliar with the arbitrage pricing theory, the amount of data that needs to be sorted through can feel overwhelming. The information is generated by a specific analyzation of the various factors involved that create growth or loss, allowing for the predictive qualities to be factors in portfolio decisions. Someone not familiar with the purpose of each data point will not understand the results APT generates, which makes it a useless tool for them.
2. It requires risk sources to be accurate.
Every portfolio encounters some level of risk. For APT to be useful, it requires investors to have a clear perception of the risk, as well as the source of that risk. Only then, will this theory be able to factor in reasonable estimates with factoring sensitivities with a higher level of accuracy. If there is no clear definition of a risk source, then there will be more potential outcomes that reduce the effectiveness of the predictive qualities that APT provides.
3. It requires the portfolio to be examined singularly.
The APT is only useful when examining a single item for risk. Because of that feature, trying to examine an entire portfolio with diverse investments is virtually impossible to do. That is why the entire portfolio is examined using the arbitrage pricing theory instead. Because it doesn’t account for each account, only the portfolio, there are certain assumptions which must be made during the evaluation. That can lead to factors of uncertainty, which reduces the accuracy of the outcomes being analyzed.
4. It is not a guarantee of results.
The arbitrage pricing theory does not guarantee that profits will happen. There are securities which are undervalued on the market today for reasons that fall outside of the scope of what APT considers. Some risks are not “real” risks, as they are built into the pricing mechanisms by the investors themselves, who have a certain fear of specific securities in certain market conditions.
The advantages and disadvantages of the arbitrage pricing theory are designed to look at the long-term average of returns. There are a handful of systematic influences which can affect this long-term average. By looking at the asset and the risks involved, a prediction of an anticipated return becomes possible. It is a good option for individual securities. When a portfolio of diverse securities is examined, however, APT may not be a suitable tool to use.