Answered Essay: 2. “Arbitrage pricing theory is an extension of the capital asset pricing model”

2. “Arbitrage pricing theory is an extension of the capital asset pricing model”. Explain this statement.

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The arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. It describes the price where a mispriced asset is expected to be and is usually viewed as an alternative to the capital asset pricing model (CAPM) because the arbitrage pricing theory assumes more flexible requirements. APT makes assumption that each investor will hold a unique portfolio with its own specific array of betas, as opposed to the identical “market portfolio”. The capital asset pricing model formula needs the market’s expected return, and the arbitrage pricing theory uses the risky asset’s expected return and risk premium of numerous macroeconomic factors. APT allows for an explanatory (as contrary to statistical) model of asset returns thus is considered as an extension of the capital asset pricing model

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