How to Test the Arbitrage Pricing Theory (APT)

Abstract

As a response to critiques about the capital asset pricing model (CAPM), Ross (1976) proposed Arbitrage Pricing Theory (APT) as an alternative model with fewer assumptions, and use of multi risk factors affecting assets prices instead of one. This article will introduce a two stage method normally called Fama-Macbeth method, to test APT. Factors affecting assets prices can be choosed among macroeconomic variables, or by using statistical techniques. The way to estimate factor scores, factor loads, and risk premiums using these two methods is explained; and at the end, APT is tested using real data’s from Tehran Stock Exchange.