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Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that...

Explain the rationale behind the Arbitrage Pricing Theory (APT) model, and discuss its empirical evidence that tests its validity.

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Arbitrage Pricing Theory (APT)

It is a tool used in pricing the stock returns. It was developed by an economist Stephen Ross in 1976. It is an alternative to CAPM. As per APT the expected return is forecasted as a linear function of macroeconomic factors that affect firm's risk. Sensitivity to change in each of these factors is represented as factor specific beta coefficient. The price of the asset is said to be equal to the price expected at the end period when discounted by this coefficient. It is used to find whether an asset is underpriced or overpriced.

Many tests have been conduicted to test its validity. It has been proived to be successful compared to CAPM.

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