Question

Describe an Arbitrage Pricing Theory (APT) model of your choice. How this model compares to the Capital Asset Pricing Model (CAPM)?

            ii) Support your answers with empirical evidence on how well models you discussed in part (i) can explain variability of returns

Answer 1

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset's returns. The APT offers analysts and investors a multi-factor pricing model for securities, based on the relationship between a financial asset's expected return and its risks.

As per assumptions under Arbitrage Pricing Theory, return on an asset is dependent on various macroeconomic factors like inflation, exchange rates, market indices, production measures, market sentiments, changes in interest rates, movement of yield curves etc.

Arbitrage pricing theory (APT) is an alternative to the capital asset pricing model (CAPM) for explaining returns of assets or portfolios. It was developed by economist Stephen Ross in the 1970s. Over the years, arbitrage pricing theory has grown in popularity for its relatively simpler assumptions

model compares to the Capital Asset Pricing Model (CAPM)

A big difference between CAPM and the arbitrage pricing theory is that APT does not spell out specific risk factors or even the number of factors involved. While CAPM uses the expected market return in its formula, APT uses the expected rate of return and the risk premium of a number of macroeconomic factors.

n some ways, the CAPM can be considered a "special case" of the APT in that the securities market line represents a single-factor model of the asset price, where beta is exposed to changes in value of the market. A disadvantage of APT is that the selection and the number of factors to use in the model is ambiguous.

APT in comparison to CAPM uses fewer assumptions and can be harder to use as well. ... While CAPM uses the expected market return in its formula, APT uses the expected rate of return and the risk premium of a number of macroeconomic factors.

The CAPM assumes that there is a linear relationship between the assets, whereas the APT assumes that there is a linear relationship between risk factors. This means that where there no linear relationship exists, the models are unable to adequately predict outcomes.

However, both the CAPM and the APT make relatively unrealistic assumptions in that assets are freely available and desirable, there are no costs incurred in the acquisition of assets and that all investors tend to think alike and come to the same conclusions. This seems intuitively contradictory, as the most successful investors are likely to be those who are able to spot potential which has remained unnoticed by the market as a whole. Indeed, when all investors do think alike, a ‘bubble’ can be created which inflates the asset price and downplays the risks inherent in the asset (Blanchard & Watson, 1982). In this circumstance, assessing the risk of an asset based on the mood of the market is likely to be far more risky than can be predicted by either the CAPM or the APT. Theoretically, therefore, it could be argued that using a CAPM or APT analysis is likely to increase the propensity for ‘bubbles’ to emerge, as they are using static predictions of behaviour by investors.

This is compounded by the subjective decisions made by analysts creating risk projections (e.g. Levy, 2012): although it may be professionally desirable for analysts to consider levels of risk in a rational and objective fashion, it is unlikely that they have no preferences or particular areas of expertise – or areas where they lack knowledge – and this will impact on the validity of the results of mathematical projections. That is, the calculation is only as good as the analyst who is choosing the factors to be included in it.

Therefore, although the CAPM and APT are useful as rule-of-thumb heuristics of the market as it currently operates, they are both static models which use a limited number of factors (Krause, 2001) to predict risk in a highly complex market. Although they are based on mathematical principles, they are subjective in that the analyst performing the calculation has the freedom to decide which factors are relevant in each particular case.

APT in comparison to CAPM uses fewer assumptions and can be harder to use as well. While CAPM uses the expected market return in its formula, APT uses the expected rate of return and the risk premium of a number of macroeconomic factors.

variability of returns

Variability refers to the divergence of data from its mean value, and is commonly used in the statistical and financial sectors. Variability is used to standardize the returns obtained on an investment and provides a point of comparison for additional analysis.