Arbitrage pricing theory
Arbitrage pricing theory assumes that asset returns can be predicted based on its expected return, as well as accounting for macroeconomic factors that affect the price of the asset. In trading, if this is true, an inefficiency can be identified and a trader could potentially profit from the difference between the “incorrect” price and the theoretical fair price.
Often, arbitrage is referred to as a “risk-free profit”, although, in reality, very few trades carry no risk. Therefore, an arbitrage trading method may provide an edge for winning, but if the arbitrage is based on assumptions and those assumptions are wrong, the trade could result in a loss. Arbitrage pricing theory is built on assumptions, which include the expected return of the asset, that interest rates won’t change, and that we can identify all variables that affect the price of the asset.
This isn’t feasible with a high degree of accuracy, but it may still alert a trader of a potential opportunity.
Arbitrage pricing theory attempts to isolate where there is a potential profit, also assuming that the price will revert to its historical tendencies. Things that are mispriced tend to revert to more realistic pricing over time. Therefore, whether the theory is used or not, the concept is important for capitalizing on these types of trading opportunities.
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