Chapter 4 The arbitrage pricing theory and multifactor models of asset returns

The Arbitrage Pricing Theory (APT) of Ross, 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). This chapter discusses the theoretical underpinnings, econometric testing, and applications of the APT. The APT is based on a simple and intuitive concept. Ross's basic insight was that a linear factor model of asset returns, in an economy with a large number of available assets, implies that idiosyncratic risk is diversifiable and that the equilibrium prices of securities will be approximately linear in their factor exposures. The chapter focuses on factor modeling of asset returns. The APT relies fundamentally on a factor model of asset returns. Theoretical derivations of the APT pricing restriction and the evidence from estimates and tests of the APT are also presented in the chapter. APT has led to new work in mathematical economics on infinite-dimensional vector spaces as models of maw-asset portfolio returns, and the properties of continuous pricing operators on these vector spaces. It has led to econometric insights about what constitutes a factor model, and how to efficiently estimate factor models with large cross-sectional data sets. It has underpinned an enormous body of empirical research on asset-pricing relationships, and on related topics such as performance measurement and cost of capital estimation.