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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)
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
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.
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