Exam ICWIM Topic 1 Question 98 Discussion

Arbitrage pricing theory explains expected returns using multiple systematic risk factors rather than relying on a single market factor. In this framework, each factor has an associated risk premium, and each security has a sensitivity to each factor. Those sensitivities are commonly described as factor betas. The expected return is constructed by adding the risk free rate to the sum of each factor beta multiplied by that factor's risk premium.
This is what makes the model multi-factor: risk is decomposed into several drivers, such as economic growth, inflation, interest rate changes, or other broad influences, with separate exposures to each. The capital asset pricing model uses one beta against a market portfolio, so it is simpler but also more restrictive. Arbitrage pricing theory does not require the strong single-factor structure and does not depend on psychological elements of investing. It also does not assume factors are correlated to each other as a defining feature. The key distinguishing point that CISI tests is that arbitrage pricing theory applies separate betas to multiple risk premiums.