Arbitrage pricing theory generalizes CAPM to multiple unspecified risk factors

Evidence

The core of arbitrage pricing theory is well described by Perry Mehrling. In the theory, “a capital asset … represents a portfolio of exposures to different risk factors whose prices are determined by the preferences of wealth holders. The price of the capital asset is then, so goes the argument, equal to the weighted sum of the risk factor prices, with the weights proportional to the exposures to each factor. The argument depends on something called the principle of no arbitrage. If the capital asset were at any other price, then some component risk factor must have an implied price that is different from its price as implied by other capital assets, and riskless arbitrage profits must be attainable by buying the risk factor at the lower price and selling it at the higher price” (Mehrling 2000, p. 83). The risk factors are not specified in the arbitrage pricing model itself, but in its empirical applications they are identified by statistical techniques. The model is in a sense a generalization of the Capital Asset Pricing Model’s single risk factor, and it predicts an overall equilibrium relationship of an analogous form: “every equilibrium will be characterized by a linear relationship between each asset’s expected return and its return’s response amplitudes, or loadings, on the common factors” (Roll and Ross 1980, p. 1074). — Donald MacKenzie, An Engine, Not a Camera, 1542

Categorization

• DEFINE: Gives a clean, quotable definition of arbitrage pricing theory and the no-arbitrage principle, useful for the reader’s performativity thesis framework.
• XREF: connects to: Testing CAPM substituted realized returns for expected returns via rational-expectations assumptions. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 111; CAPM promised a simple tradeoff hidden beneath Wall Street’s apparent complexity — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 255; Mean-variance portfolio theory requires the restrictive quadratic utility assumption. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 588 (+1 more)