Question

General equilibrium models of asset pricing allow us to determine the relevant measure of risk for any asset and the relationship between expected return and risk.

Two of these models have been subject to fierce debate among practitioners and academics, The Capital Asset Pricing Model (CAPM) and The Arbitrage Pricing Model (APT). Based on the assumptions and tests of each model you are asked to:

1. Critically analyse the assumptions of both models.

2. Discuss the similarities and differences between them.

3. If you are a portfolio manager and had to choose one of the models, which one would you pick up and why?

In the analysis, students are advised to look into issues such as:

a. The ability of each model to explain systematic risk.

b. Usefulness in predicting excess expected returns.

c. Ability of each model on building up a well-diversified portfolio.

d. Main empirical findings related to the models.

Answer 1

CAPM

According to CAPM, there is an equilibrium relationship between risk and return
for each security. Under the conditions of market equilibrium, a security is expected to
provide a return commensurate with its unavoidable risk. The greater the unavoidable risk
of a security, the greater the return that investors will expect from the security. The
relationship between the expected return and unavoidable risk and the valuation of
securities is the essence of CAPM. Stated in other words, “the risk averse investors will not
hold risky assets, unless they are adequately compensated for the risks, they bear”.

The following are the important assumptions of the model.
1. Investors make their decisions only on the basis of the expected return, risk associated
with the security.
2. An individual investor cannot influence the price of a stock in the market.
3. Investors can lend or borrow funds at the riskless rate of interest.
4. Assets are infinitely divisible.
5. There are no transaction costs involved on buying and selling of stocks.
6. There is no personal income Tax.

One of the larger implications of the CAPM is that it can be used for pricing of the
securities. It provides a framework for assessing whether a security is over-priced, under-
priced or correctly priced.

Arbiterage pricing theory

Arbitrage is a process of earning profit by taking advantage of differential
pricing for the same asset. The process generates riskless profit. In the security market, it is
of selling security at a high price and the simultaneous purchase of the same security at a
lower price. Since the profit earned through arbitrage is riskless, the investors have the incentive to undertake this whenever an opportunity arises.

The assumptions:
1. The investors have homogenous expectations.
2. The investors are risk averse and utility maximisers.
3. Perfect competition prevails in the market and there is no transaction cost.

Similarities and differences

Arbitrage pricing theory is one of the tools used by the investors and portfolio
managers. The capital asset pricing theory explains the returns of the securities on the
basis of their respective betas. According to the previous models, the investor chooses the
investment on the basis of expected return and variance. The alternative model developed
in asset pricing by Stephen Ross is known as Arbitrage Pricing Theory. The APT theory
explains the nature of equilibrium in the asset pricing in a less complicated manner with
fewer assumptions compared to CAPM.

CAPM and APT are both asset pricing model and consisers risk premiums and both agreess on return beta relationship.

Conclusion

The fact that both models have their merits. The main advantage of CAPM is its simplicity. As the asset price is only related to one other variable, it is comparatively easy to calculate the CAPM rate of return. While APT requires you to determine which variables are relevant to a particular asset, and then calculate the sensitivities for all of them. However, if you can manage this then APT is likely to give a more accurate and reliable result.

Deciding which model to use dependes on time and information available.If you have access to the relevant variables to construct an APT model, then it is more beneficial Otherwise, CAPM is a better. alternative.

Finally, you may want to consider whether you are pricing a single asset or a portfolio. For a single asset, accuracy is likely to be a priority, which could lead to you favouring APT. For a portfolio, the inaccuracy of CAPM can b avoided due to complex calculations and models required of APT.