Global Advisors | Quantified Strategy Consulting

William Sharpe

Arbitrage Pricing Theory (APT) explains asset returns through multiple systematic market factors (e.g., inflation, interest rates, GDP growth), not just market risk like CAPM. It assumes no arbitrage opportunities exist—mispriced assets are quickly corrected by investors—creating a stable risk-return relationship. This flexibility makes APT adaptable to complex, real-world market dynamics.

Term: Arbitrage Pricing Theory: A Comprehensive Framework for Multi-Factor Asset Pricing

Modern Portfolio Theory (MPT), introduced by Harry Markowitz in1952, is a mathematical framework for constructing portfolios that optimise the trade-off between risk and return. It posits that portfolio risk is not just the sum of individual asset risks but depends on their correlations and covariances. By using mean-variance analysis, MPT identifies the efficient frontier—a set of optimal portfolios offering the highest expected return for a given risk level or the lowest risk for a target return. Diversification, driven by low-correlation assets, is central to reducing unsystematic risk. MPT revolutionised finance by providing a systematic, quantitative approach to portfolio construction, earning Markowitz the1990 Nobel Prize and forming the foundation for modern asset allocation and risk management practices.

Term: Modern Portfolio Theory – Mean-Variance Analysis and the Efficient Frontier

The Capital Asset Pricing Model (CAPM) quantifies the link between an asset’s systematic risk and its expected return, proposing that investors require higher returns for taking on increased market risk.

Term: The Capital Asset Pricing Model (CAPM)

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