Question

2)   Discuss the shortcomings of the capital asset pricing model. How does the arbitrage pricing model address these shortcomings? Discuss the major shortcoming of the arbitrage pricing model? Explain which model is more useful in your opinion.

Answer 1

ANS: CAPM describes the relationship between systematic risk & expected return for assets.Using CAPM Ke is calculated.

Ke = Risk free rate (Rf) + Beta (Market return(Rm) - Risk free rate)

CAPM has some limitation due to which investors not being able to diversify the portfolio in a planned manner & Beta varies from method to method, remaining unstable which donot reflect the true risk involved. Further, CAPM cannot be used in isolation so the financial manager use it with other techniques to develop realistic & useful for cost of equity calculation.

The Arbitrage Pricing Theory (APT) is a theory of assets pricing that holds an assets return; It is a multi-factor pricing model based on relationship between expected return & risk.

Some disadvantages of APT are-

• Involves large amount of data which makes difficult to understand the purpose & the Outcomes.
• Factor of uncertaininty reduces the accuracy of outcomes
• APT dosenot gaurantee the profit
• APT dosenot specify the systematic factors.

CAPM has advantage of being easy to calculate the rate of return ; But APT requires determination of variables as per their sensitivity, Thus, APT is more likely to give accurate & reliable result.