CAPM AND APT

CAPM and APT Model - A Comparative Analysis

Table of Contents

Introduction1

Capital Asset Pricing Model1

Assumptions of the Model2

Criticisms of CAPM Model3

Arbitrage Pricing Theory4

Analysis of both Models6

Differences between APT and CAPM6

Conclusions7

References8

CAPM and APT Model - A Comparative Analysis

Introduction

One of the major challenges to be faced over time in the theory of finance was to find a mathematical model that would allow the investors to quantify the amount of compensation that exists in the capital market between performances expected return of an asset with the respective risk. Where, unless someone has information, it is not possible to obtain an asset a return higher than other paper without incurring a higher level of risk.

Capital Asset Pricing Model

The first major theoretical advancement that attempted to answer this question was the Capital Asset Pricing Models or CAPM presented by Sharpe (1964) and Linter (1965). Capital Asset Pricing Model or CAPM is a financing model used to evaluate the value of market portfolios by examining the relating systemic risk and the expected return. In actuality, the theory divides risk into two categories of risk, systemic and specific. Although, the capital asset pricing model only reimburses investors for the systemic risk of the holding a portfolio since specific risk can be diversified away (Jagannathan 1995, 2-17). Risk in the capital asset pricing model is assumed as wanting to be avoided but if risk is accepted then investors expect to be rewarded, called risk premium. In addition to the risk premium paid to the investor, he or she will also be rewarded the risk free return rate.

The same model postulated that under certain conditions regarding the distribution of asset returns, investors have homogeneous expectations and their portfolios are efficient in terms of the mean and variance (the portfolio has the highest return possible for given level of risk). Also, in the absence of market frictions, the expected return of an action is linearly related to the covariance between the return on assets and performance of the market portfolio (called beta coefficient), assuming one can lend and borrow at the risk free rate. Such that when the market is in equilibrium, the investor only pays for the systematic risk or non diversifiable risk as the risk of the assets is itself removed without costs through diversification of portfolio (Lawrence 2008, 32-47).

The capital asset pricing model is a powerful tool for corporate capital budgeting and performance measurement. The CAPM takes into account the sensitivity of the asset at risk non-diversifiable, known as market risk or systematic risk, represented by the symbol of Beta (ß), as well as expected market return and the expected return of an asset theoretically risk-free.

E (Ri) = Rf + ßi (E(Rm) - Rf)

Financial managers can use capital asset pricing model for making a number of decisions concerning financial dispositions.

Assumptions of the Model

The assumptions used in the Capital Asset Pricing Model (CAPM) are similar in that they assume an almost “perfect world” scenario (Horne 2008, 10-47).

The model assumes various aspects of investors and markets:

Individuals are ...