MScFE: Econometrics

11 March 2019

Collaborative Review Task M1

CAPM and APT
1. Differences between CAPM and APT (Arbitrage Pricing Theory)
The Capital Asset Pricing Model (CAPM) quantifies the relationship between the price of a
risky asset and the systematic risk prevalent in the financial markets. The formula for CAPM
is given as:
Expected return on investment = risk free rate + beta*(market risk premium)
Here, the beta measures the riskiness of the asset compared to the market. A beta greater
than 1 implies that the security is more risky than the market whereas a beta less than implies
that the security is less risky than the market.
Arbitrage Pricing Theory (APT) is a multi-factor model which postulates that the price of a
security can be estimated using the linear relationship between the expected return on the
asset and the macroeconomic variables that capture systematic risk. The formula for the APT
is given as:
Expected return on asset = risk free rate + (sensitivity of the asset price to macroeconomic factor n)*(risk
premium associated with factor I - risk free rate)

There are a few key differences between CAPM and APT. Where CAPM assumes that the
markets are perfectly efficient, APT is not bounded by any such limitation and assumes that
markets can misprice securities which can be exploited.
CAPM is a single factor model (market risk) unlike APT which has multiple factors
(macroeconomic factors) which must be analytically determined.

2. What model would you choose between CAPM and APT? Indicate research
papers on this topic. Provide arguments to support your choice.
I would choose the APT model for the pricing of assets. This choice stems out of various
research papers that have analysed the predictability of both CAPM and APT models to
price assets, where APT seems to have a slight upper edge as compared to CAPM. It can be

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utilised to manage large pool of funds where the portfolio strategy decision involves choosing
the desirable degree of exposure to the fundamental economic risks which influence not only
asset returns but also organisations (Roll, Ross). APT models also enable priced factors that
statistically independent of the market returns (Galagedera). This is especially important as
we want more than one measure of systematic risk to measure asset returns and also these
measures to be independent of market return.
The single factor CAPM also has another limitation that when the portfolio used as market
portfolio is inefficient it leads to the rejection of the CAPM theory.
Another research paper by Dhankar, Singh argues that APT may lead to better estimates of
expected returns and the asset risk than CAPM in the Indian stock market context. This is
especially encouraging as it provides empirical evidence of outperformance of APT
compared to CAPM albeit with certain caveats like the kind of sample, time period and
estimation methods used.

References:
1. Dhankar, R. S., & Singh, R. (2005). ARBITRAGE PRICING THEORY AND THE
CAPITAL ASSET PRICING MODEL-EVIDENCE FROM THE INDIAN STOCK
MARKET. Journal of Financial Management & Analysis, 18(1), 14-27. Retrieved from
https://search.proquest.com/docview/215227623?accountid=174648
2. Roll, R., & Ross, S. A. (1995). The arbitrage pricing theory approach to strategic
portfolio. Financial Analysts Journal, 51(1), 122. Retrieved from https://
search.proquest.com/docview/219234635?accountid=174648
3. Don U.A. Galagedera. (2007). A review of capital asset pricing models. Managerial Finance,
33(10), 821-832. doi:http://dx.doi.org/10.1108/03074350710779269

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