Question

Discuss the advantages of the multifactor APT over the single factor APT and the CAPM. What is a key shortcoming of the multifactor APT? How does this key shortcoming compare to CAPM implications?

Answer 1

Single factor arbitrage pricing theory and the Capital Asset pricing model will be assuming that there is only one systematic risk which is affecting the stock return and that systematic risk will be reflected by the beta.

However, it can be seen that various factors will be affecting the stock returns and some of these factors will be business cycle and interest rate fluctuation along with inflation risk and political risk and other systematic risk which can never be managed so multifactor model can accommodate all these multiple sources of risk.

One of the shortcoming of multi factor arbitrage pricing theory is that this model provides no guidance concerning the risk premium on the factor portfolios.

Capital Asset pricing model will be implying that the risk premium on the market is determined by the markets variance and degree of risk aversion across various investors so risk premium will be accounted by Capital Asset pricing model and then it will be multiplied by beta with addition to risk free return in order to arrive at an expected rate of return.