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Describe The Differences Between CAPM and APT

The document discusses the differences between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). It analyzes factors to consider when choosing between the two models such as complexity, accuracy, and practicality. It argues that APT should be favored for pricing single assets while CAPM can be used for portfolios.

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3K views

Describe The Differences Between CAPM and APT

The document discusses the differences between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). It analyzes factors to consider when choosing between the two models such as complexity, accuracy, and practicality. It argues that APT should be favored for pricing single assets while CAPM can be used for portfolios.

Uploaded by

douglas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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1. Describe the differences between CAPM and APT.

Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are used to
determine the theoretical rate of return on an asset or portfolio of assets. CAPM was developed in
the 1960s by Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin while APT was
developed in 1976 by Stephen Ross as an alternative for CAPM. Below table shown measure
diffrences of Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT).

CAPM APT

Year 1960 1976


Developed By Jack Treynor, William F. Sharpe, John Stephen Ross
Lintner, and Jan Mossin
Definition The capital asset pricing model (CAPM) The arbitrage pricing theory (APT) as
to determine the theoretical appropriate an alternative to the CAPM. The APT
rate that an asset should return given the introduced a framework that explains
level of risk assumed. the expected theoretical rate of return
of an asset, or portfolio, in
equilibrium as a linear function of the
risk of the asset, or portfolio, with
respect to a set of factors capturing
systematic risk.
Formula Rit − Rft = ai + βi (Rmt − Rft) + εit rj = ai + bi1F1 + bi2F2 + ⋯ + binFn
+ εi
Complexity Since the CAPM is a one-factor model The arbitrage pricing theory is an
and simpler to use, investors may want alternative to the CAPM that uses
to use it to determine the expected fewer assumptions and can be harder
theoretical appropriate rate of return to implement than the CAPM.
rather than using APT, which requires
users to quantify multiple factors.
Key Differences At first glance, the CAPM and APT The APT formula has multiple factors
formulas look identical, but the CAPM that include non-company factors,
has only one factor and one beta. which requires the asset's beta in
relation to each separate factor.
2. What model would you choose between CAPM and APT?
Indicate research papers on this topic. Provide arguments to support
your choice.

While both models are used to price an asset, one model is more relevant and practical
when pricing an asset at a given time. Choosing which model to use can be determined by a
number of factors. These factors include;

1. Level of risk as the main determinant of pricing the asset

2. Is It A Single Asset or A Portfolio

3. Accuracy of the Price

4. Access To Time and Relevant Variables

5. Factors considered during the calculation and simplicity

6. Time used to determine asset price

7. Accuracy of the results

8. Practicality and ease of use

Level Of Risk As The Main Determinant Of Pricing The Asset - There are many factors that
make an investment in an asset risky. Some of these factors could be macroeconomic or company-
specific. These factors are very relevant and important when pricing an asset and should be
included. In the CAPM model, the expected return of an asset is a linear function of market risk,
while in APT model, the expected return of an asset is a linear function of numerous unknown risk
factors. (Lekovic, and Stanisic) . This makes the APT model more reliable and practical in this
case.

Is It A Single Asset or A Portfolio - For a single asset, accuracy is the priority.(Corbett). From the
discussion above on the differences between CAPM and APT, APT is more accurate since it
considers multiple factors and it is an extension of CAPM.

“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.” - Corbett

Accuracy Of The Price - APT has proven to be more accurate than and gives more reliable results
as compared to CAPM.

Access To Time and Relevant Variables - Since APT takes into account multiple factors, if you
have access to relevant information on the factors then use them to construct an APT model which
can be used to price an asset. Additionally, the time you need to make the decision should be long
enough to allow for the construction of the model and pricing of the asset since APT requires you
to determine the variables and then calculate the sensitivities for all of them.

Factors considered during the calculation and simplicity - One factor is considered that the
expected market return (Rm) . This makes it more simple to use when pricing an asset.
Time used to determine asset price - Less time since we use one beta one factor.

Accuracy of the results - Fewer factors are equivalent to less accurate. Due to the nature of its
factors, CAPM can cause a lot of inaccuracies for small stocks and value stocks. CAPM also
makes a lot of assumptions, for example, it assumes an individual can borrow and lend at a risk-
free rate.

Practicality and ease of use - The only factor considered is the market risk premium, which is
easy to calculate and more practical since the market keeps changing fast.

Conclusion :

For single assets, APT should be favoured while a portfolio can use CAPM on individual assets to
avoid multiple calculations. CAPM is relatively easy to calculate so computing it first, and
evaluating if it is good is a good starting point then you can continue to evaluate the APT. CAPM
and the APT model are complementary models that complete each other.

References :

https://www.investopedia.com/articles/markets/080916/capm-vs-arbitrage-pricing-
theory-how-they-differ.asp
https://medium.com/@samarakoon.gayan/capital-asset-pricing-model-and-arbitrage-
pricing-theory-which-one-when-ebdb06f5bdf
https://medium.com/@mercymwangi1996/capm-vs-apt-ad35bb0b2db5
https://kubicle.com/blog/capm-vs-apt-which-one-is-right-for-you/

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