Differentiate between Arbitrage Pricing and Capital Asset Pricing Theory

If the company being observed has no gearing in it, the beta value obtained depends only on the type of business being carried on. If, however, the company has gearing within it, the beta value will reflect not only the risk arising from the company, but also the risk arising from gearing. Might suggest that the rate of return would be lowered if the company reduced its dividends or the growth rate.

  1. In this article, we will explore the attributes of APT and CAPM, highlighting their similarities and differences.
  2. Might suggest that the rate of return would be lowered if the company reduced its dividends or the growth rate.
  3. This shows the relationship between market risk and expected return or describes the relationship between the expected rate of return.

The formula for the capital asset pricing model is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate. Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. The theory assumes an asset’s return is dependent on various macroeconomic, market and security-specific factors. Arbitrage pricing theory, as an alternative model to the capital asset pricing model, tries to explain asset or portfolio returns with systematic factors and asset/portfolio sensitivities to such factors. Any difference between actual return and expected return is explained by factor surprises (differences between expected and actual values of factors).

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While CAPM is simpler to use and widely accepted, APT provides a more comprehensive and flexible framework for estimating expected returns, making it suitable for more complex investment scenarios. One of the most controversial assumptions of the CAPM is that returns are normally distributed, which implies that agents have quadratic utility functions. This assumption guarantees the mean-variance efficiency of the market portfolio. Also, it leads to a linear equilibrium relation between the expected return on an asset and its sensitivity to the expected market premium (i.e., beta risk). Using this linear relation, Ross (1971, 1974, 1976) developed the arbitrage pricing theory (APT).

Estimating Factor Sensitivities and Factor Premiums

Both APT and CAPM employ factor analysis to determine the expected returns of assets. CAPM focuses on a single factor, the market risk, which is represented by the beta coefficient. On the other hand, APT considers multiple factors that can influence asset returns, such as interest rates, inflation, industry-specific factors, and macroeconomic variables. APT allows for a more comprehensive analysis of the factors affecting asset prices.

The Importance of Working Capital Management for Companies

CAPM’s assumption of a perfectly efficient market may not hold in reality, as markets can be influenced by various inefficiencies and behavioral biases. Additionally, CAPM’s reliance on historical data for estimating beta coefficients may not accurately capture future market conditions. APT, although more flexible, requires the identification and estimation of relevant factors, which can be challenging and subjective. It also assumes that the relationship between factors and asset returns is linear, which may not always be the case.

Another distinction between APT and CAPM lies in the calculation of expected returns. CAPM uses a simple linear equation to estimate the expected return of an asset. It multiplies the risk-free rate by the asset’s beta coefficient and adds the market risk premium. This approach assumes a linear relationship between the asset’s risk and expected return. APT, on the other hand, employs a multi-factor model to estimate expected returns.

In arbitrage, two transactions are carried out at the same time in two separate markets. However, typical changing market conditions may decrease profit immensely when they conduct CAPM evaluations. For example, if a portfolio has a beta of 1.25 in relation to the Standard & Poor’s 500 Index (S&P 500), it is theoretically 25% more volatile than the S&P 500 Index. They do not give you the weighted average cost of capital other than in the very special circumstances when a company has only equity in its capital structure. The beta of an asset measures the theoretical volatility compared to the overall market, meaning that if a portfolio has a beta of 1.5 compared to the S&P 500, then it is theoretically going to be 50 percent more volatile than the S&P.

However, CAPM’s reliance on the assumption of a single market factor may limit its accuracy in certain situations where other factors play a significant role. APT, on the other hand, is more flexible and can accommodate a broader range of factors. It is particularly useful when analyzing assets in specific industries or regions where unique https://1investing.in/ factors may influence returns. When it comes to investment analysis and portfolio management, two widely used models are the Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM). Both models aim to provide insights into the expected returns of assets, but they differ in their underlying assumptions and methodologies.

In the 1960s, Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin developed the capital asset pricing model (CAPM) to determine the theoretical appropriate rate that an asset should return given the level of risk assumed. Thereafter, in 1976, economist Stephen Ross developed the arbitrage pricing theory (APT) as an alternative to the CAPM. The APT introduced a framework that explains 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.

It assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the identical “market portfolio”. In some ways, the CAPM can be considered a “special case” of the APT in that the securities market line represents a single-factor model of the asset price, where beta is exposed to changes in value of the market. Recall that in the capital asset pricing model, we derived asset beta, which measures asset sensitivity to market return, by simply regressing actual asset returns against market returns. At first glance, the CAPM and APT formulas look identical, but the CAPM has only one factor and one beta. Conversely, the APT formula has multiple factors that include non-company factors, which requires the asset’s beta in relation to each separate factor.

In conclusion, both APT and CAPM are important models that investors can use to estimate the expected return of a stock or portfolio. While they share some similarities, they differ in the number of risk factors they consider, their assumptions about the market, and their treatment of arbitrage. Investors should carefully consider the strengths and weaknesses of each model before using them to make investment decisions. The CAPM allows investors to quantify the expected return on an investment given the investment risk, risk-free rate of return, expected market return, and the beta of an asset or portfolio.

The CAPM has gained widespread use because it provides restrictions for investors’ portfolios and asset prices and returns that appear to be validated by data on a variety of securities. The beta coefficients in the APT model are estimated by using linear regression. In general, historical securities returns are regressed on the factor to estimate its difference between capm and apt beta. APT is reliable for the medium to long term but is often inaccurate for short-term calculations. This gives it an advantage over CAPM simply because you do not have to create a similar portfolio for risk assessment. Factor (risk) premium is the additional return that must be offered to the investor for him to take on the additional factor risk.

The former approach exploits a risk-return relationship for the pricing of assets whereas the latter imposes a factor structure. These approaches also have implications for the theory of portfolio choice. The first question that comes to mind is, “What returns can I expect, given the level of risk I am assuming? ” This is precisely where the Capital Asset Pricing Model, or CAPM, comes into play. Developed by economist William Sharpe in the 1960s, the CAPM provides a framework to quantify the relationship between an asset’s expected return and its systematic risk. While both APT and CAPM offer valuable insights, they also have their limitations.

Over the years, arbitrage pricing theory has grown in popularity for its relatively simpler assumptions. However, arbitrage pricing theory is a lot more difficult to apply in practice because it requires a lot of data and complex statistical analysis. In conclusion, APT and CAPM are two popular models used in investment analysis and portfolio management. While they share similarities in their use of factor analysis and estimation of expected returns, they differ in their assumptions, number of factors considered, and calculation methodologies. CAPM is simpler and widely used, assuming a single market factor, while APT allows for a more comprehensive analysis of multiple factors.

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