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APT vs CAPM

APT vs CAPM

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Published by Jimmy Braimah

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Published by: Jimmy Braimah on Nov 11, 2012
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IntroductionManaging portfolio and investing in stocks is very risky and could be tricky, as a result, financial experts andinvestors view it as necessary or smart to know what to expect when they invest. Due to this, different statisticalmodels have emerged to attempt to scientifically measure the potential returns on an investment. The CapitalAsset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two of such models. The purpose of this essay is to critically compare the Arbitrage Pricing Theory with the Capital Asset Pricing Model as used byfund managers in the United Kingdom.Captial Asset Pricing Model (CAPM)When Sharpe (1964) and Lintner (1965) proposed the Capital Asset Pricing Model (CAPM), it was seen as aleading tool in measuring if an investment will yield in positive or negative returns. It attempts to explain therelationship between investment risk and expected reward of risky securities (Ushad, 2011; Reilly and Brown,2011; Heshmat, 2012). The CAPM helps to determine the required rate of return for any risky asset (Reilly andBrown, 2011).“The CAPM states that the expected return on a security or a portfolio equals the rate on a risk-free security plusa risk premium” (Heshmat, 2012: 504). It indicates that the expected return on an asset has a positive linear relationship with the non-diversifiable risk of the security (beta) (Heshmat, 2012). Ushad (2011) explains thatthe CAPM is based on the premise that higher returns should be associated with higher beta risks. It
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a)
Managing portfolio and investing in stocks is very risky and could be tricky, as aresult, financial experts and investors view it as necessary or smart to know what toexpect when they invest. Due to this, different statistical models have emerged toattempt to scientifically measure the potential returns on an investment. The CapitalAsset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two of such models. The purpose of this essay is to critically compare the Arbitrage PricingTheory with the
 
Capital Asset Pricing Model as used by fu
n
d managers in the UnitedKingdom.Captial Asset Pricing Model (CAPM) b)When Sharpe (1964) and Lintner (1965) proposed the Capital Asset Pricing Model (CAPM),it was see
n
as a leading
t
ool in measuring if an investment will yi
e
 
i
n
 p
o
sit
i
ve
δ 
o
r n
e
 ga
δ 
i
veretu
ns
δ 
t
ε 
tte
mpts
 
to explai
n
the
e
ationship between investment risk and expected reward of risky securities (Ushad, 2011;
 R
eilly and Brown, 2011; Heshmat, 2012). The CAPM helps todetermine the required
ate of return for any risky asset (Reilly and Brown, 2011).“The CAPM sta
t
δ 
 s
that the expected return on a security or a portfolio equals the rate on arisk-free security p
l
ε 
 s
a risk premium” (Heshmat, 2012: 504). It indicates that the expectedreturn on an asset has a positive linear relationship with the non-diversifiable risk of thesecurity (beta)
(H
eshmat, 2012). Ushad (2011) explains that the CAPM is based on the
 
 premise that higher returns should be associated with higher beta risks. It 3i3s33u3s3u3a3l3l3y3 3c3a3l3c3u3l3a3t3e3d3 3a3s3 3f3o3l3l3o3w3s3:3 3E3(3R3i3)3=3 3R3f33+3 3²i3 3(3E3(3R3m3)3 3-3 3R3f3)3.3 3(3U3s3h3a3d3,3 323031313)3.33W3h3e3r3e3,3 3E3(3R3i3)3 3=3 3r3e3t3u3r3n3 3r3e3q3u3i3r3e3d3 3o3n33f3i3n3a3n3c3i3a3l3 3a3s3s3e3t3 3i33R3f3 3=3 3r3i3s3k3-3f3r3e3e3 3r3a3t3e3 3o3f3 3r3e3t3u3r3n33²i3 3=3 3t3h3e3 3s3e3n3s3i3t3i3v3i3t3y3 3o3f3 3t3h3e3 3a3s3s3e3t3 s3 3r3e3t3u3r3n33t3o3 3t3h3e3 3m3a3r3k3e3t33E3(3R3m3)3 3=3 3a3v3e3r3a3g3e3 3r3e3t3u3r3n3 3o3n3 3t3h3e3 3c3a3p3i3t3a3l33marketSharpe (1964) and Lintner (1965) proposed various assumptions that the CAPM must takeinto consideration. According to Watson and Head (2007
)
, Reilly and Brown (2011), theseassumptions include:Investors can lend or borrow at a risk free rateAll unsystematic, that is non-market, risks are eliminatedA standardised holding period is assumed by the CAPM in order to make comparable thereturns on different securities. Thus a single-period transaction horizonTransaction costs and taxes are excludedAll investors have equal access to all securitiesThe CAPM has often been criticised as being very unrealistic because it assumes thatinvestment is made in an ideal world. However, Watson and Head (2007) stress that in realworld situations, investment decisions are made by individuals and companies. Anothecriticism is that in real world situations, investors cannot lend or borrow at a risk free rate.This is because individual investor risk is usually hig
he
r t
h
at that of 
t
he government (Watsonand Head, 2007). They also argue that though CAPM assumes that investment ta
ke placeover single-period time horiz 
on, experience indicates that in the re( 1990) analysed UK  pr ivate sector 
da
ta, it was foun
d
out that the CAPM may not be applicable in the UK. ThoughCAPM suggests a positive linear relationship with rates of return and system
atic risks, thereis evidence that which ind 
icates that additional risk variables n0 11). Thus Ramadan (2012)stresses
t
hat another mod
el
like the Arbitrage Pricing Theory (APT) which reflects a linear multi-factor relatio
nship in addition to systematic risk and other ma
croeconomic factorsneeds to be considered.

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