Arbitrage Pricing Theory (APT), first introduced by Stephen Ross in 1976, is an asset pricing model used to explain the relationship between an asset’s expected return and a variety of macroeconomic factors. Essentially, APT explains the fair value of an asset by using a linear combination of macroeconomic factors.

These macroeconomic factors typically explain systematic, market-wide risk, including factors such as inflation, exchange rate and industrial production. Sentiment related factors, such as consumer confidence and changes in policies, are also covered in the APT model. The idea is that any changes in these macroeconomic factors can have a direct impact on an asset’s expected return. APT is an alternative to the more familiar Capital Asset Pricing Model (CAPM), which assumes that markets are efficient and that any mispricing of securities is quickly corrected by the market.

When using APT to estimate an asset’s fair value, the analyst uses a variety of macroeconomic factors that can be used to gauge an asset’s systematic risk. In other words, the analysts attempt to identify factors that might directly influence the expected return of the asset. When all these macroeconomic factors are identified and the researchers find the fair value of the asset, they can then use the data to check for any discrepancies between the fair value and the actual market price of the asset. If there are any discrepancies, the analyst can take advantage of them and potentially take a long or short position in the asset and make a profit on the discrepancy.

APT, however, has several shortcomings. Firstly, the number of macroeconomic variables that should be included in the model is a subject of debate. Secondly, it is difficult to accurately estimate a fair value for the asset, since systematic risks such as macroeconomic factors cannot be fully predicted. Lastly, the APT model is not suitable for use in the long term since it is a transient, equilibrium-based model that is only suitable for short-term predictions.

Despite its shortcomings, APT has revolutionized the way asset pricing and risk management are viewed by offering a more detailed approach to understanding the relationship between an asset’s expected return and macroeconomic factors. The APT model can also be used to gain insight into how macroeconomic factors affect the asset prices and can potentially identify mispricing of securities, which can provide arbitrageurs with the opportunity to take advantage of those inefficiencies. As a result, the Arbitrage Pricing Theory has become a cornerstone of modern finance.