You are on page 1of 6

Comparing the Arbitrage Pricing

Theory and the Capital Asset


Pricing Model:
There are inherent risks in holding any asset, and the capital
asset pricing model (CAPM) and the arbitrage pricing model (APM)
are both ways of calculating the cost of an asset and the rate of
return which can be expected based on the risk level inherent in
the asset.
The Capital Asset Pricing Model (CAPM) is a special case of the
Arbitrage Pricing Model (APT) in that CAPM uses a single factor
(beta as sensitivity to market price changes) whereas the APT has
multiple factors which may not include the CAPM beta.
CAPM is considered 'demand side' in that it is based on the
market's aggregation of individual investors' utility maximization
curves. APT is 'supply side' in that it usually includes
macroeconomic factors.
Capital Asset Pricing Model
The CAPM formula is:
ra = rrf + Ba (rm rrt)
where ra is the rate of return for a risk-free security
rm is the broad market expectation on the rate of return
B is the beta of the asset
The figures used for rrf, rm and Ba are decided on by the analyst,
although most investors use a Beta figure which has been
1

calculated by a third party. The most common use for the CAPM
is calculating the fair price of an asset.
Arbitrage involves making two simultaneous transactions in two
markets, taking advantage of the differences in price between the
two markets. Technically arbitrage is considered to be risk-free,
but fluctuations in market conditions may reduce expected profit
in normal times, and can be severely affected by events such as
devaluations.
Issues with the CAPM:
The CAPM makes several assumptions:
There are no transaction costs (e.g. taxes)

Assets are dividable


There are no restrictions to investment in assets
Investors will maximize their expected utility
Prices cannot be influenced by investors
There is a homogeneity of beliefs
All assets are marketable
The calculations are on a single time period
There are issues over the linearity of the equation used to
calculate the CAPM, but perhaps the most critical issue is that
recent calculations have shown that the CAPM calculations do not
match empirical results.

Arbitrage Pricing Theory:


The Arbitrage Pricing Theory (APT) was developed by Ross (1976)
as a substitute for the CAPM. The basic principle of the APT is
that the payoff from each asset can be described as a weighted
average of all assets in a portfolio.

The APT formula is:

E(rj) = rf + bj1RP1 +bj2 RP2 +......bjnRPn


Where E(rj) is the expected rate of return on the asset
Rf is the risk-free rate
Bj is the sensitivity of the assets return in this particular case
RP is the risk premium in this particular case

The thinking behind the APT is that there are two main issues
which can influence the rate of return on an asset: the
macroeconomic environment in general and how likely it is that
the environment might influence the movement of the asset.
Influences in the macroeconomic environment include inflation,
levels of confidence of investors, changes in interest rates, and so
on.
The assumptions made by the APT are:
It is assumed that returns will follow the above equation

Investors tend towards risk aversion


There are no transaction costs
There are no restrictions on the availability of assets
Short sales are not restricted

No arbitrage possibilities exist (in equilibrium)


All investors think alike.
Issues with the APT

The major issue with the APT is attempting to accurately define


the level of risk which applies to any given asset. It may be
possible to find a factor portfolio where the risks are very
similar, but generally the level of risk is determined by
macroeconomic factors.

Comparison between the CAPM and the APT:


APT may be informative over the medium to long term, but are
not considered to be accurate in the short term. The CAPM, on
the other hand, is a snapshot, and appears to be more accurate in
the short term than it is in the long term.
The APT focuses on risk factors rather than assets, so it has an
advantage over the CAPM in that it does not have to create an
equivalent portfolio to assess risk.
The CAPM assumes that there is a linear relationship between the
assets, whereas the APT assumes that there is a linear
relationship between risk factors. This means that where there
no linear relationship exists, the models are unable to adequately
predict outcomes.

However, both the CAPM and the APT make relatively unrealistic
assumptions in that assets are freely available and desirable,
there are no costs incurred in the acquisition of assets and that
all investors tend to think alike and come to the same
conclusions. This seems intuitively contradictory, as the most
successful investors are likely to be those who are able to spot
potential which has remained unnoticed by the market as a
whole. Indeed, when all investors do think alike, a bubble can
be created which inflates the asset price and downplays the risks
inherent in the asset. In this circumstance, assessing the risk of
an asset based on the mood of the market is likely to be far more
risky than can be predicted by either the CAPM or the APT.
Theoretically, therefore, it could be argued that using a CAPM or
APT analysis is likely to increase the propensity for bubbles to
emerge, as they are using static predictions of behavior by
investors.

This is compounded by the subjective decisions made by analysts


creating risk projections: although it may be professionally
desirable for analysts to consider levels of risk in a rational and
objective fashion, it is unlikely that they have no preferences or
particular areas of expertise or areas where they lack
knowledge and this will impact on the validity of the results of
mathematical projections. That is, the calculation is only as good
as the analyst who is choosing the factors to be included in it.

Therefore, although the CAPM and APT are useful as rule-ofthumb heuristics of the market as it currently operates, they are
both static models which use a limited number of factors (Krause,
2001) to predict risk in a highly complex market. Although they
are based on mathematical principles, they are subjective in that

the analyst performing the calculation has the freedom to decide


which factors are relevant in each particular case.
One of the great advantages of the CAPM is its simplicity. But to
test the CAPM two problems arise. Firstly, the CAPM is concerned
with expected returns and secondly, the market portfolio should
include all risky investment, whereas most of the market indexes
contain only a sample of common stocks.

You might also like