Arbitrage Pricing Theory

When you’re engaged in arbitrage, you’re taking advantage of a market where a product sells for different prices. Say Bob’s Market sells a dozen bananas for $1.00, and Joe’s Market across town sells a dozen for $1.25. By buying bananas at Bob’s and immediately selling them for profit at Joe’s, you’re engaging in arbitrage.

Investors use the arbitrage pricing theory to identify an asset that’s incorrectly priced. Investors can profit by using the theory to identify a mispriced asset and take advantage before its price is corrected. Markets with security prices that offer arbitrage opportunities usually change those prices quickly.

The arbitrage pricing theory weighs the influence of different macroeconomic factors on an asset’s return. If the asset’s price is different than the model’s projection, an opportunistic investor can buy and sell the asset for profit. Until the price changes, risk is low.

Those macroeconomic factors can include economic output, unemployment, inflation, savings or investments-specific considerations. As a factor changes, so, too, will an asset’s value. Perhaps the trickiest part of the arbitrage pricing theory is it forces investors to identify factors that might influence an asset, which is not easy to do.

Stephen Ross developed the arbitrage pricing theory in the 1970s. It’s used as an alternative to the capital asset pricing model, which is typically used to place a fair price on a stock by considering its risks and rate of return.