The Arbitrage Pricing Theory and Multifactor Models of Asset Returns

The Arbitrage Pricing Theory (APT) of Ross (1976, 1977), and extensions of that theory, constitute an important branch of asset pricing theory and one of the primary alternatives to the Capital Asset Pricing Model (CAPM). In this chapter we survey the theoretical underpinnings, econometric testing, and applications of the APT. We aim for variety in viewpoint without attempting to be all-inclusive. Where necessary, we refer the reader to the primary literature for more complete treatments of the various research areas we discuss. In Section II we discuss factor modelling of asset returns. The APT relies fundamentally on a factor model of asset returns. Section III describes theoretical derivations of the APT pricing restriction. Section IV surveys the evidence from estimates and tests of the APT. In Section V we discuss several additional empirical topics in applying multifactor models of asset returns. We survey applications of the APT to problems in investments and corporate finance in Section VI. We provide some concluding comments in Section VII.