Holicent
VIP Contributor
Arbitrage pricing theory is a substitute for Stephen Ross's capital asset pricing model, which also relies only on arbitrage theory. The APT suggests that there are numerous risk considerations that must be considered when determining risk-adjusted performance or alpha.
Arbitrage theory holds that risk-adjusted returns can be measured by the difference between two prices (the return on the "underlying" and the return on the "hedge"). Arbitrage pricing theory uses discounted cash flow analysis to determine how much a hedge will cost for any given level of risk.
For example, if you were to invest in a stock that was expected to grow at 10% per year, and you were able to find an undervalued stock that would return 9% per year, it would make sense to invest in this stock because it provides better value than your benchmark. This model assumes that you could find another company with similar characteristics and buy their shares (called a "replacement") at their current price.
Arbitrage theory holds that risk-adjusted returns can be measured by the difference between two prices (the return on the "underlying" and the return on the "hedge"). Arbitrage pricing theory uses discounted cash flow analysis to determine how much a hedge will cost for any given level of risk.
For example, if you were to invest in a stock that was expected to grow at 10% per year, and you were able to find an undervalued stock that would return 9% per year, it would make sense to invest in this stock because it provides better value than your benchmark. This model assumes that you could find another company with similar characteristics and buy their shares (called a "replacement") at their current price.
