CAPM and APT Chapter 4 Asset Pricing for Dynamic Economies

The only factor you need to consider is the market risk premium, which is reasonably easy to calculate. APT, by contrast, requires more time and expertise from the analyst, both in determining which factors to include for each asset and in calculating the sensitivities for each of those factors. While CAPM assumes that assets have a straightforward relationship, APT assumes a linear connection between risk factors. That means if there is no linear relationship, the models cannot accurately determine outcomes. Since the CAPM is a one-factor model and simpler to use, investors may want to use it to determine the expected theoretical appropriate rate of return rather than using APT, which requires users to quantify multiple factors. By include other variables like firm size and book-to-market ratio, the Fama-French Three-Factor Model makes an effort to overcome some of the shortcomings of CAPM.

The capital asset pricing model (CAPM) provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate. Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. The theory assumes an asset’s return is dependent on various macroeconomic, market and security-specific factors.

Using this linear relation, Ross (1971, 1974, 1976) developed the arbitrage pricing theory (APT). Based on no-arbitrage conditions, the APT is a more general asset pricing model than the CAPM. Arbitrage Pricing difference between capm and apt Theory (APT) is a framework that seeks to explain asset prices by considering the relationship between an asset’s expected return and its exposure to various systematic risk factors. In conclusion, a solid understanding of the mathematical framework of APT, including risk factors and the arbitrage pricing equation, is crucial for accurately applying the theory and making informed investment decisions.

By identifying relevant risk factors and estimating their coefficients, investors can align their portfolios with the factors that are most likely to influence returns, potentially achieving superior risk-adjusted returns. It is worth noting that the arbitrage pricing equation provides a framework for assessing an asset’s expected return based on its exposure to risk factors. This equation is a powerful tool that helps investors understand the underlying drivers of an asset’s performance and make informed investment decisions. A fundamental asset pricing model that is frequently used in finance is the Capital Asset Pricing Model (CAPM), which was created by Sharpe and Lintner in 1964. According to CAPM, an asset’s expected return is defined by its beta, which indicates how sensitive the asset’s returns are to those of the entire market. Investors need to be compensated for holding riskier assets, according to CAPM, in the form of greater expected returns.

Decoding the Puzzle of Asset Pricing: Beyond the CAPM

Simultaneously, however, APT has certain shortcomings or weaknesses that could lead to inaccurate risk estimates, making the overall investment process riskier. As traders exploit arbitrage opportunities, they indirectly contribute to the adjustment of asset prices. The act of buying low and selling high eventually leads to a balance, with the prices of identical or similar assets aligning across different markets. Finally, these foundational elements come together in the actual pricing formula.

Round 2: Empirical accuracy

1. Furthermore, the CAPM model presupposes that stock prices accurately reflect all important information, which implies that markets are efficient (Lintner, 1965).
2. It is based on the idea that investors should be compensated for bearing systematic risks, which cannot be diversified away.
3. Deciding which model to use ultimately depends on the specific investment context and the availability of relevant data.
4. We have to determine the systematic factors by which portfolio returns are explained.

A value greater than 1 suggests the asset is more volatile than the market, and less than 1 indicates less volatility than the market. Each risk factor in the multi-factor model carries its beta, leading to what is known as factor-specific betas. The choice between APT and CAPM depends on the specific investment context and the availability of relevant data.

The Formula for the Arbitrage Pricing Theory Model Is

The theory was developed with the assumption that the prices of securities are affected by many factors, which can be sorted into macroeconomic or company-specific factors. We’ll also assume that the annual expected return of the portfolios are 7% for the S&P 500 Total Return Index and 9% for the NASDAQ Composite Total Return Index. APT is reliable for the medium to long term but is often inaccurate for short-term calculations. This gives it an advantage over CAPM simply because you do not have to create a similar portfolio for risk assessment. The main problem with APT, however, is that it tries to accurately measure the risk for all assets. While you can determine a “factor portfolio” (reflecting very similar risks), the risk level is still essentially influenced by macroeconomic factors.

Given that CAPM is relatively easy to calculate, I suggest computing this initially, and then evaluating whether it is worthwhile to continue to evaluate the APT. Either method should give you a reasonable estimate of whether an asset merits your investment at the current time. Estimating the empirical performance of APT is a more difficult job, as the usefulness of the model is dependent on the choice of factors, however the APT does generally perform well empirically.

CAPM assumes that the expected return of an asset is solely determined by its beta, which measures its sensitivity to market movements. On the other hand, APT takes into account multiple factors that can influence an asset’s return, such as interest rates, inflation, and industry-specific variables. While CAPM is simpler to use and widely accepted, APT provides a more comprehensive and flexible framework for estimating expected returns, making it suitable for more complex investment scenarios. The theory’s multi-factor model provides the framework for creating a balanced portfolio, taking into account the sensitivity of various assets to changes in macroeconomic factors. Using APT, investors can determine the expected return of a portfolio based on each asset’s beta and the risk premium for each factor.