Arbitrage Pricing Theory (APT) differs from the Capital Asset Pricing Model (CAPM) in hypothesizing that actual and expected security returns are sensitive, not to just one type of nondiversifiable risk (i.e., beta or market risk), but to a variety of different types of risk. Prior testing has shown the CAPM to be inferior to an APT model that incorporates unanticipated changes in five macroeconomic variables—default risk, the term structure of interest rates, inflation or deflation, the long-run expected growth rate of profits for the economy and residual market risk.
It is possible to estimate the sensitivities of individual securities or portfolios to these five risk factors. Such measurements allow one to explore variations in sensitivities to different types of risk across both equity market sectors and industries. The resulting risk exposure profiles do not depend on any particular market index.
APT risk profiles may be used for either active or passive portfolio management. Passive managers wishing to reduce their portfolios’ systematic risk characteristics might consider a technique termed “risk sterilization”; here assets with different risk profiles are combined so as to negate, or sterilize, exposure to selected risk factors. Alternatively, active managers can attempt to achieve excess returns by constructing portfolios in accordance with their forecasts of risk factor realizations.