NOTE: Free essay sample provided on this page should be used for references or sample purposes only. The sample essay is available to anyone, so any direct quoting without mentioning the source will be considered plagiarism by schools, colleges and universities that use plagiarism detection software. To get a completely brand-new, plagiarism-free essay, please use our essay writing service.
One click instant price quote
APT Vs. CAPM, Which One is Best Approach by Financial Professionals First of all, lets examine both Arbitrage Pricing Theory and Capital Asset Pricing Model. The Arbitrage Pricing Theory is a sound alternative to the Capital Asset Pricing Model. The APT offers us an alternative explanation to CAPM concerning risk-expected return relationships. The Arbitrage Pricing Theory specifies returns as a linear function of more than one single factor, whereas the Capital Asset Pricing Model usually specified returns as a linear function of only one factor systematic risk.
The Arbitrage Pricing Theory. Lets explain the main basics of the Arbitrage Pricing Theory. The APT divides systematic risk into smaller component risks. Recent research has suggested that the 4 -factor version of the APT is better at predicting the return on a stock than the simplest version of the CAPM.
In some of its basic ideas, but not in its details, the APT builds on rather than replaces the CAPM (Risk and Return, n. p. ) E (ri? rf) = E (rj? rf)?
i? j According to Financial Markets: Theories and Evidence, the Arbitrage Pricing Theory rests on the following assumptions: The returns are generated according to a linear factor model; What is linear factor model? ri = E (ri) +? i F +?
i? i asset is sensitivity to the common factors; f common factor, with? (F) = 0; Ei firm-specific return, with zero mean, and independent of the common factor or other firms idiosyncratic component (Investment Classes 6: The CAPM and APT Part 1 theory); The number of assets are close to infinite; Investors have homogenous expectations (however, this assumption is the same as the Capital Asset Pricing Model proposes); Capital markets are perfect (the Capital Asset Pricing Model has the same assumption as well). As for two first assumptions, they are the subjects to debates. The Capital Asset Pricing Model According to the Investment Classes 6: The CAPM and APT Part 1 theory, the CAPM is based on the following assumptions: Perfect markets (the same as the APT). What does it mean? It means perfect competition, no transaction costs, no short-sale constraints, no taxes, the assets are traded publicly and are perfectly divisible.
The risk-free rate is the same both for landing and borrowing. Identical investors It means that the holding period is the same, the homogenous expectations, normality or mean-Variance utility, etc. So, does it mean that APT is stronger than CAPM? It is very difficult to claim that one theory is stronger than another. At the same time, the APT claims that relatively new factors generate correlation (Burton 20 - 28) and states that the expected returns on a security or an asset class ought to be a function of its exposure to those relatively new factors. These facts fully agree with the main idea of the Capital Asset Pricing Model.
However, the Arbitrage Pricing Theory considers that the expected return you get for |exposure to factor three could be anything (Burton 20 - 28), whereas the Capital Asset Pricing Model claims that it can be not, if factor three does badly in bad times, the expected return for exposure to that factor ought to be high. In case that factor represented by a certain random event that doesnt correspond to assumption whether the times are bad or good, then the expected return ought to be zero. The Arbitrage Pricing Theory is obviously stronger if we speak about the return-generating processes. At the same time the APT is weaker than the CAPM because the theory doesnt give us much information about the expected return on those factors. The Capital Asset Pricing Model, in contrast to the APT, offers more sound explanation regarding the assumption of how people with preferences determine prices in the market (Burton 20 - 28). The CAPM seems to provide the people with more thorough and concise explanations.
The Capital Asset Pricing Model doesnt demand the exact quantity of factors and whatever number of factors there may be, the expected return of a security will be related to its exposure to those factors (Burton 20 - 28). So, does it mean that the CAPM is better? Actually, it isnt. The majority of economists consider that the Arbitrage Pricing Theory came as a result of dissatisfaction with the main positions of the Capital Asset Pricing Model. Although the university textbooks still have the CAPM for examination, claiming that the CAPM represents a very fundamental economic argument, the Arbitrage Pricing Theory is considered to be a relatively new and effective economic theory that predicts a relationship between the returns of portfolio and the returns of a single asset through a linear combination of variables (Investopedia. com Website, n.
p. ) Bibliography: Burton, J. Revisiting the Capital Asset Pricing Model. Dow Jones Asset Manager. May/June 1998, pp. 20 - 28. Financial Markets: Theories and Evidence. Lecture 9.
The Arbitrage Pricing Theory, APT. retrieved May 11, 2006. web Investment Classes 6: The CAPM and APT Part 1 theory. retrieved May 11, 2006. web Investopedia. com Website.
Arbitrage Pricing Theory APT. Retrieved May 11, 2006. web RISK AND RETURN. The Economist; London; Feb 2, 1991
Free research essays on topics related to: expected return, financial markets, capital asset pricing, systematic risk, asset pricing model
Research essay sample on Capital Asset Pricing Asset Pricing Model
