A Comparison of CAPM and APT

Capital Asset Pricing Model(CAPM)1

CAPM allows investors to calculate the expected return on an investment given the risk,
risk-free rate of return, expected market return and the beta of an asset. Beta measures the
volatility in relation to the market. CAPM is calculated using the formula :

E(ri) = rf + bi * (E(rM) – rf)

Where,

Rf is the risk-free rate of return

Arbitrage Pricing Theory (APT)2

APT is an alternative to CAPM. It uses fewer assumptions and may be harder to implement
than CAPM. The assumption behind the model is that the prices of securities are driven by
multiple factors. The APT does not indicate the identity or the number of risk factor. APT
gives the associated expression for the asset’s expected return. APT formula uses an asset’s
expected rate of return and the risk premium of multiple macroeconomic factors.

APT could be expressed using the formula :

Ri= ai + bi1 * F1 + bi2 * F2 +. …..+ bin * Fn +ei

Where,

Ai is a constant for the asset

Differences between CAPM and APT3

1
Will Kenton, ‘Capital Asset Pricing Model (CAPM)’, Investopedia, accessed 14 December 2020,
https://www.investopedia.com/terms/c/capm.asp.
2
Adam Hayes, ‘Understanding Arbitrage Pricing Theory’, Investopedia, accessed 14 December 2020,
https://www.investopedia.com/terms/a/apt.asp.
3
Steven Nickolas, ‘CAPM vs. Arbitrage Pricing Theory: What’s the Difference?’, Investopedia, accessed 14
December 2020, https://www.investopedia.com/articles/markets/080916/capm-vs-arbitrage-pricing-theory-
how-they-differ.asp.
 • CAPM has only one relevant factor : the sensitivity of the asset to changes in the
market. APT states that the return on an asset is dependent on its sensitivity to
various factors, which can be macroeconomic or company specific.
• In CAPM the sensitivity is called beta and it is a key attribute of any asset. In APT
sensitivities are computed using a linear regression of historical returns of the asset
on the relevant factor.
• CAPM has only one factor and one beta. Conversely, the PAT formula has multiple
factors that include non-company factors, which requires the asset’s beta in relation
to each separate factor.
• In CAPM the factor used is the difference between the expected market rate of
return and the risk-free rate of return. In APT, there are no insights on what the
factors could be.
• CAPM is simpler to use and may be preferred by investors over APT which requires
users to work with multiple factors

Choosing between CAPM and APT4 5

Simplicity

From the above sections we can observe that APT will be more accurate than CAPM if
additional factor are accounted. APT requires the user to spend extra time and effort to
decide the factors after gathering the relevant data.

CAPM is simple to calculate. The only factor to consider is the market risk premium, which is
reasonably easy to calculate. Since only one factor is needed, users can compute CAPM
quickly. APT, by contrast , requires more time and effort both in determining factors and
calculating the return.

Choosing factors on an asset is not easy and changes over time. Different APT has to be
defined for different each asset to maximize accuracy. Factors considered for APT model
change over time and may not make sense at a future point of time.

The advantage of CAPM is that it does not have any such problems and the model contains
a single factor every time.

Accuracy

APT was developed as an extension to CAPM. CAPM is not accurate in empirical tests. There
are size effects and value effects which cause inaccuracies in CAPM for small stocks and
value stocks.

4
‘CAPM vs APT. Which One Is Right for You? | Kubicle Blog’, accessed 14 December 2020,
https://kubicle.com/blog/capm-vs-apt-which-one-is-right-for-you/.
5
Nickolas, ‘CAPM vs. Arbitrage Pricing Theory’.
Estimating empirical performance of APT is a more difficult job, as lot of factors are
involved. But compared to CAPM APT performs better. Performance is better because
assumptions are less and real world factors are accounted for.

Conclusion

Both CAPM and APT have their merits and both have been used since their inception. In
today’s fast paced environment, CAPM has an upper hand because of its simplicity. The
returns will be calculated depending on one factor. For a portfolio the inaccuracy of CAPM
on individual assets may be less of a problem than the multiple calculations and models
required of APT. Computing APT requires very much time and effort for identifying the
factors. These factors are susceptible to change. Hence APT is challenging than CAPM.
CAPM is to compute for a portfolio.

Reference:

1. ‘CAPM vs APT. Which One Is Right for You? | Kubicle Blog’. Accessed 14 December 2020.
https://kubicle.com/blog/capm-vs-apt-which-one-is-right-for-you/.
2. Hayes, Adam. ‘Understanding Arbitrage Pricing Theory’. Investopedia. Accessed 14
December 2020. https://www.investopedia.com/terms/a/apt.asp.
3. Kenton, Will. ‘Capital Asset Pricing Model (CAPM)’. Investopedia. Accessed 14 December
2020. https://www.investopedia.com/terms/c/capm.asp.
4. Nickolas, Steven. ‘CAPM vs. Arbitrage Pricing Theory: What’s the Difference?’
Investopedia. Accessed 14 December 2020.
https://www.investopedia.com/articles/markets/080916/capm-vs-arbitrage-pricing-
theory-how-they-differ.asp.