What is 'arbitrage pricing theory' (APT) based on?

Arbitrage Pricing Theory (APT) is fundamentally based on the premise that the return on an asset can be modeled as a linear function of various macroeconomic factors or theoretical market indices. It posits that asset returns are influenced by multiple factors that can be systematic in nature, such as inflation rates, interest rates, and economic growth indicators, allowing this model to capture the risk-return profile effectively.

Unlike the Capital Asset Pricing Model (CAPM), which relies on a single factor (market risk), APT allows for a more nuanced view as it accommodates a diverse set of risk factors. Investors can potentially take advantage of mispricings in the market by using APT to determine whether an asset is undervalued or overvalued based on its relationship to these underlying macroeconomic influences.

The other options do not correctly encapsulate the foundational basis of APT. The first option revolves around bond yields, which are specific to fixed-income securities, rather than a broader economic framework. The third option also focuses on fixed income, which does not align with APT's broader application to multiple asset classes. Finally, while diversified investment portfolios are relevant in many investment theories, they are not the core basis of APT. Thus, the correct understanding