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Design a Tool to Apply CAPM and Arbitrage Pricing Theory

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Design a Tool to Apply CAPM and Arbitrage Pricing Theory

Introduction

The purpose of the task is to explain the principles of the Capital Asset Pricing Model

(CAPM), and Arbitrage Pricing Theory, and to calculate the estimated return of investment from

the CAPM formula for the given sets of scenarios along with a detailed explanation and analysis

of calculations. CAPM is the pricing model that describes the relationship between the expected

return of assets, and systematic risks, for stocks, while APT is the pricing model based on the

return on assets, and it predicts the linear relationship between the macroeconomic variables and

expected return of assets. In this report, CAPM for Apple Inc. is calculated on an excel sheet

based on the given data sets along with the calculation of APT for Coca-Cola and AT &T with

formulas in an excel spreadsheet.

Calculation of Expected Rate of return By CAPM

The expected rate of return is calculated for Apple Inc. in an excel spreadsheet with

assumption values such as the risk-free rate or 10-year treasury rate is 1.00 percent, and market

return for 10 years is given as 8.00 percent. The beta of Apple is taken as 0.75 as given in the

data set. The estimated return of the assets is calculated in the excel spreadsheet, which is 6.25

percent according to the formula for the expected return of investment (Will, 2022). The formula

set for the calculation of the expected return of investment according to the CAPM model along

with the excel formula is given in the excel spreadsheet.

Calculation of Expected Rate of Return by APT Model – Coca Cola

Similarly, Arbitrage Pricing Theory (APT) for Coca-Cola is calculated from the given

data sets and APT for AT&T is calculated by estimating the factors of Forecasts, Bond, Size,
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ROE (Return on Equity), and Beta values from different sources. The factor forecasts are given

in the range of -1.50 percent to 6.00 percent for the calculation of APT for AT&T and Coca-Cola

Inc. The APT is calculated for the excess return of the industry forecast factor of 5.00 percent for

both AT &T and Coca-Cola Inc. The growth factor for Coca-Cola Inc. has a factor forecast of

2.50 percent, and its growth factor is calculated as 0.02. Similarly, the Coca-Cola, government

bond market is calculated as 0.3 with a forecasting factor of 2.50 percent. The equity

capitalization and return of equity for Coca-Cola are 1.41 and 1.48 respectively with a factor

forecast of -1.50 percent and 0.00 percent. Finally, the beta value of Coca-Cola is 1.06 in the data

set. The formula for the calculation of APT is developed in the excel spreadsheet which is the

sum product of the factor forecasts and Factor loadings given in the data sets, and APT for Coca-

Cola is calculated as 3.59 percent.

Calculation of Expected Rate of Return by APT Model – AT&T

The values for forecast factors of AT&T are calculated from different sources to calculate

the APT. The excess return of industry forecast for AT &T is taken as 5.00 percent, the same as

Coca-Cola Inc. The beta value of AT& T is given as 0.60 which is given in the statistical stock

table for AT&T (Yahoo Finance, 2022). The return on equity for AT&T is 0.114 according to

the stock market trend for AT&T (Macro Trend, 2022). Similarly, the growth factor for AT&T is

calculated as 0.106 according to the Growth Grade and underlying factors of AT &T (Alpha,

2022). Finally, equity capitalization and bond values for AT &T are assumed to be 1.47 and 0.74

as relational comparison factors given for Coca-Cola Inc. The APT for AT&T is calculated

according to the formula in the excel spreadsheet which is the sum of products of the factors

forecasts and factor loadings. The APT for AT& T is calculated as 4.43 percent which is slighter

higher than Coca-Cola Inc.

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Analysis of Calculation

The higher value of APT for AT&T shows the higher value for the expected rate of return

of investments for AT&T in comparison to Coca-Cola Inc. The value of the APT depends upon

many factors, and changing any of the factors has a direct effect on the value of APT. The factors

forecasts for both of the calculation remains the same, however, the difference lies in the value of

the beta factor, return on equity, market capitalization, government bond factors, and growth

factor for AT&T. The bond factor and market capitalization are higher for AT&T in comparison

to the values for Coca-Cola Inc. Due to these two factors in the formula, the value of the APT or

expected return of an investment calculated for AT&T is higher than Coca-Cola. The values of

all these factors are not constant and change due to several external and internal factors which

can change the value of APT.

Conclusion

The formulas for the calculation of CAPM and APT are developed in the excel

spreadsheet, which calculates the expected return of investment for any given value of data sets.

However, to calculate the expected return of investment by the CAPM model, there is a need for

the risk-free rate and market return along with the beta value. But, the expected return of

investments by the APT model, needs a value of growth factor, beta, equity capitalization, return

on equity, and government bond value. From the knowing values of these factors along with the

industry factor forecasts, the expected return of investment is calculated according to the APT

model. The major difference between the APT and CAPM is that APT calculates the expected

return on investment based on the values of the beta which is the sensitivity to the factor n. The

values of Beta are calculated by running a regression of quarterly data against the Treasury bond

yield change and GDP growth rate.

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References

Will Kenton (2022). Investopedia. Capital Asset Pricing Model (CAPM)

https://www.investopedia.com/terms/c/capm.asp

AT&T (2022). Yahoo Finance. Statistical Stock Quote.

https://finance.yahoo.com/quote/T/key-statistics?ltr=1

Macro Trend (2022). AT&T

https://www.macrotrends.net/stocks/charts/T/at-t/roe

Seeking Alpha (2022). Growth Grade and underlying Matrices. AT&T.

https://seekingalpha.com/symbol/T/growth