Question

Describe the underlying assumptions and differences for the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Provide an example in which type of situation each would be most appropriate to the task. Is there any situation in which using either method would be acceptable? Or neither, and if so, which pricing model would then be most appropriate? Explain.

Answer 1

Assumptions in CAPM-

1. Personal income tax is zero.
2. No transaction cost
3. Investors are rational and risk takers
4. Money can be borrowed any amount at risk free rate.

Assumptions of Arbitrage Pricing Theory-

1. Return on investment depends upon many factors like inflation, economic conditions, company specific conditions, exchange rate, yield curve etc.
2. It is based on the theory that all traders trade for profit maximization.
3. It also assumes there is no arbitrage exists.

Difference between Capital Asset Pricing Model and Arbitrage Pricing Theory-

1. CAPM has only one factor, i.e. beta, risk free rate etc. while APT has several factors like macro economic and company specific.
2. CAPM is easier to calculate than APT, CAPM is more widely used that APT.

Conclusion- CAPM is more appropriate as it is a single factor model and easier to calculate and understand for beginners. CAPM condsiders systematic risk that is not taken in other models.