Question

"The Capital Asset Pricing Model (CAPM) has historically been used to provide investment managers and analysts with a method of determining a rate of return to apply to stock valuations. While very useful, the model is constrained regarding the number of factors it takes into account. Is this model rich enough to result in a useful rate of return?

Is the Arbitrage Pricing Theory more useful?  What are some of the important differences?"

Answer 1

CAPM historically has been used by the managers to estimate the required rate of return on equity security. The major issue that comes with the use of CAPM model is that it assumes that the non-systematic risk is diversified away and the investor is only being compensated for the systematic risk being taken. However in real world scenario this is not always true because investors does not always diversify enough to eliminate the non-systematic risk and there the arbitrage pricing theory is alternative to the CAPM model as it does not limit the risk to only one factors, APT allows investors to attribute risk premium to many factors that can affect the risk of the security. APT model is slightly more useful than the CAPM model as it allows risk premium to be attributed to more than one factors and not just beta. The APT model also does not make any assumption about the empirical distribution of the asset returns and this can be easily applied to multiple period framework.