is a well-known method of estimating the price of anasset. The theory assumes an assets return is dependent on various macroeconomic,marketand security-specific factors.

APTis an alternative to thecapital asset pricing model (CAPM). Stephen Ross developed the theory in 1976.

E(rj) = rf+ bj1RP1+ bj2RP2+ bj3RP3+ bj4RP4+ … + bjnRPn

bj= the sensitivity of the assets return to the particular factor

RP = the risk premium associated with the particular factor

The general idea behind APT is that two things can explain the expected return on a financial asset: 1) macroeconomic/security-specific influences and 2) the assets sensitivity to those influences. This relationship takes the form of the linearregressionformula above.

There are an infinite number of security-specific influences for any given security includinginflation, production measures, investor confidence, exchange rates, market indices or changes in interest rates. It is up to theanalystto decide which influences are relevant to the asset being analyzed.

Once the analyst derives the assets expected rate of return from the APT model, he or she can determine what the correct price of the asset should be by plugging the rate into a discountedcash flowmodel.

Note that APT can be applied to portfolios as well as individual securities. After all, a portfolio can have exposures and sensitivities to certain kinds of risk factors as well.

The APT was a revolutionary model because it allows the user to adapt the model to the security being analyzed. And as with other pricing models, it helps the user decide whether a security isundervaluedorovervaluedand so he or she canprofitfrom this information. APT is also very useful for building portfolios because it allows managers to test whether their portfolios are exposed to certain factors.

APT may be more customizable than CAPM, but it is also more difficult to apply because determining which factors influence astockor portfolio takes a considerable amount of research. It can be virtually impossible to detect every influential factor much less determine how sensitive the security is to a particular factor. But getting close enough is often good enough; in fact studies find that four or five factors will usually explain most of a securitys return: surprises in inflation, GNP, investor confidence and shifts in theyield curve.

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