What is arbitrage pricing theory (APT)?

Arbitrage Pricing Theory (APT) is indeed an alternative to the Capital Asset Pricing Model (CAPM) that incorporates multiple factors in asset pricing. Unlike CAPM, which relies on a single market risk factor (the market portfolio), APT allows for a more nuanced analysis by considering various systematic factors that could affect an asset's return. These factors might include economic indicators, inflation rates, interest rates, and other variables that may impact financial markets.

The strength of APT lies in its flexibility; it provides a framework for investors to identify how different factors interact and influence asset prices without being tied to the strict assumptions that CAPM makes, such as market efficiency and investor behavior. This multi-faceted approach helps explain asset returns better, particularly in complex and dynamic markets.

In contrast to the other options, APT does not simplify asset pricing to a single factor – shown in the misunderstanding of whether it emphasizes only interest rates or focuses purely on trading efficiency or execution methods. APT is fundamentally about the relationship between multiple risk factors and expected returns, acknowledging that investors must consider a wider array of influences when assessing the value of an asset.