FINANCIAL ECONOMICS

Financial Economics

Financial Economics

Essay 1: APT and CAPM

In many respects, the APT is considered a general case of the CAPM. The APT model is advised better to the CAPM as it integrates multiple financial components to interpret security returns. The CAPM can be examined as an exceptional case of the APT. The assumptions of the APT model are furthermore less restrictive than those of CAPM. APT does not, for demonstration, suppose a lonely time span horizon, or that buying into conclusions are made inside a mean-variance context-that is, different CAPM it does not suppose that investors address their portfolios in periods of needed comes back and variance. To designated day, the APT model is still in its relation infancy. The empirical work, which has so far been finished, does not supply any conclusive outcomes on the efficacy of the model. In deduction, both the APT and CAPM manage offer us alternate conceptual structures for seeking to realise the attachments between risks and return and, therefore, the task of valuing securities. However, academics and investigators are still a long way from evolving a universal asset pricing model and the theory of asset pricing continues in a bewildered state.

Limitations of CAPM

Investors might disagree about the expected returns and variances of the returns on available securities. In this case, a market portfolio based on the weighted averages of all investors' expectations will still be efficient, but individual investors may prefer to take positions on their own perceived risk-return frontiers. Some investors may be unable to sell short without restriction. These investors would operate on a constrained efficient frontier. In this case, the aggregate market index is not efficient. If different investors (perhaps including foreign investors) face different marginal tax rates on income or capital gains, each investor's after-tax risk-return frontier will be different (Roll 1980: 87).

Different investors have different human capital, and they should take this into account in determining their efficient portfolios. A worker in a car factory perhaps should not include shares in car manufacturers, in his portfolio. Therefore, each investor's perceived risk-return frontier is different. The idea that expected return and standard deviation of return are the only two properties of the distribution of returns that matter to investors is based on an assumption that returns are normally distributed. However, in practice returns may be non-normally distributed, and investors may have preferences (for characteristics such as skewness) different to those we have assumed.

The Absence Of Arbitrage

A cantered characteristic of the APT model is that it supposes no arbitrage that is in market equilibrium there are no possibilities to profit from arbitrage profits. Arbitrage is the method of benefiting from mispriced securities. Strictly talking arbitrage engages producing risk-free earnings with no outlay. This is in compare to untainted conjecture, which engages risk-taking, occasionally substantial risk-taking, to make profits. An arbitrage opening happens where the identical security deals for two different prices, generally, but not inevitably, in two separate supply markets. Arbitrageurs will purchase the security where it is underpriced ...