Arbitrage Pricing Theory

Definition: APT is a fundamental pricing model that informs traders about expected returns using economic theory and particular asset pricing strategies. APT can be used in various markets, including capital markets, technology, and real estate. The basic idea is to identify prices commonly obtained using a multiple-factor pricing model of variable order. The factors can be anything from corporate profits, interest rates, material costs of production, bargaining power in terms of workers or resources, pre-tax profits, or returns on equity invested in the company. The price can be used as a proxy for predicted future profits.

Arbitrage pricing theory gives investors a way to improve their returns by exploiting price shifts in markets significantly. Market participants with limited knowledge of price action may fail to recognize opportunities presented by these price shifts. In addition, the analysis uncovered by this tool can help investors identify securities that are likely to generate profitable trading opportunities in the future.

Arbitrage pricing is the process of spotting price discrepancies between two or more markets. When prices are misaligned, there is a profit to be made in either direction, but not in both. Thus, it offers several advantages to investors: uncovering pricing discrepancies enables investors to profit from writing checks to companies that have overcharged them (i.e., the profit comes from taking profit from under-delivering), discovering under-deliveries allows investors to earn more than they would if all prices were correct and markets were perfectly efficient.

The APT incorporates fundamental shifts in the cost of capital while retaining the efficiency attributes of the traditional CAPM framework. Most importantly, it accounts for large quadratic effects in pricing—that is, changes in prices due to changing costs for inputs are larger than changes in prices due to changes in the quality or costs of the final output. 

APT and CAPM are both approaches to pricing. They both use pricing theory to model the optimal prices for a product or service. However, they approach this problem slightly differently.  APT uses calculations based on historical data to determine prices for products that have historically sold at those prices. Because there is always some risk in trading, this approach tends to be more emotionally appealing to traders.

The basic concept of arbitrage pricing theory states that pricing is not driven by a single factor but is continually influenced by many factors. In simple words, the price of goodwill always is dependent on supply and demand. This phenomenon can be used to your advantage in various markets because it allows you to scan the prices of goods and services displayed on various websites and adjust your purchase accordingly.

In the simplest terms, APT refers to exploiting pricing discrepancies in the marketplace. By pricing your products or services differently from others, you can either capture more of the total value of your sales or pass along some of that profit to your customers. This concept has been implemented in several different ways, but the basic idea isn’t new.

Arbitrage pricing theory(APT) says that an individual or firm can profit from different prices between markets with different quality information. By studying publicly available data about each market and applying efficient processes to produce accurate estimates of fair market value, arbitrageurs can profit by offering to buy products below their perceived value in one market and selling them in another at a higher price. In other words, they can increase value while minimizing risk.