The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns  can be forecasted with the linear relationship of an asset’s expected returns and the macroeconomic factors that affect the asset’s risk. 

The APT suggests that investors will diversify their portfolios, but that they will also choose their own individual profile of risk and returns based on the premiums and sensitivity of the macroeconomic risk factors. Risk-taking investors will exploit the differences in expected and real returns on the asset by using arbitrage.

The APT suggests that the returns on assets follow a linear pattern. An investor can leverage deviations in returns from the linear pattern using the arbitrage strategy. Arbitrage is the practice of the simultaneous purchase and sale of an asset on different exchanges, taking advantage of slight pricing discrepancies to lock in a risk-free profit for the trade.

The APT’s concept of arbitrage is different from the classic meaning of the term. In the APT, arbitrage is not a risk-free operation – but it does offer a high probability of success. What the arbitrage pricing theory offers traders is a model for determining the theoretical fair market value of an asset. Having determined that value, traders then look for slight deviations from the fair market price, and trade accordingly.

For example, if the fair market value of stock A is determined, using the APT pricing model, to be $13, but the market price briefly drops to $11, then a trader would buy the stock, based on the belief that further market price action will quickly “correct” the market price back to the $13 a share level.