ARBITRAGE PRICING THEORY∗
August 15, 2005
Focusing on asset returns governed by a factor structure, the APT is a one-period
model, in which preclusion of arbitrage over static portfolios of these assets leads to a
linear relation between the expected return and its covariance with the factors. The
APT, however, does not preclude arbitrage over dynamic portfolios. Consequently,
applying the model to evaluate managed portfolios contradicts the no-arbitrage spirit
of the model. An empirical test of the APT entails a procedure to identify features
of the underlying factor structure rather than merely a collection of mean-variance
efficient factor portfolios that satisfies the linear relation.
Keywords: arbitrage; asset pricing model; factor model.
∗S. N. Durlauf and L. E. Blume, The New Palgrave Dictionary of Economics, forthcoming, Palgrave
Macmillan, reproduced with permission of Palgrave Macmillan. This article is taken from the authors’
original manuscript and has not been reviewed or edited. The definitive published version of this extract
may be found in the complete The New Palgrave Dictionary of Economics in print and online, forthcoming.
†Huberman is at Columbia University. Wang is at the Federal Reserve Bank of New York and the
McCombs School of Business in the University of Texas at Austin. The views stated here are those of the
authors and do not necessarily reflect the views of the Federal Reserve Bank of New York or the Federal
The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a, 1976b).
It is a one-period model in which every investor believes that the stochastic properties
of returns of capital assets are consistent with a factor structure. Ross argues that if
equilibrium prices offer no arbitrage opportunities over static portfolios of the assets,
then the expected returns on the assets are approximately linearly related to the factor
loadings. (The factor loadings, or betas, are proportional to the returns’ covaria