Arbitrage Pricing Theory (APT), developed by Stephen Ross in 1976, is a multi-factor asset pricing model that expresses the expected return of a security as a linear function of multiple macroeconomic risk factors rather than just one market factor as in CAPM. Each factor has its own beta (sensitivity) and risk premium. Common factors used in APT models for Indian equity markets include GDP growth surprises, inflation changes, interest rate movements, industrial production data, and foreign institutional investor flows. APT is built on the principle that if assets were mispriced relative to their factor exposures, arbitrageurs would exploit the discrepancy until prices corrected. While theoretically flexible, APT's practical application requires identifying the correct risk factors and estimating their premiums — tasks that are empirically challenging. APT underpins many quantitative and factor-based investment strategies used by institutional investors in India.
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