In contrast to the CAPM, the APT does not indicate which factors are expected to determine...

In contrast to the CAPM, the APT does not indicate which factors are expected to determine the risk premium of an asset. How can we determine which factors should be included? For example, one risk factor suggested is the company size. Why might this be an important risk factor in an APT model? Also, what is the the relationship between the one-factor model and the CAPM?

Expert Solution

As per CAPM (Capital asset pricing model), the return of stock is determined in relation to the marke's return. One of the important assumption of such model is that an average investor holds market portfolio so that an investor will probably earn return with respect to market. In other words, an investor will be facing the market risk for which he will be compensated for the risk during the bad times. However in case of APT (Arbitraging pricing model), there are multiple factors which are incorporated into the model to determine the return for the stock. Such factos could be categorized under macroeconomic factors and investment style factors. These factors were not incorporated in traditional model (CAPM).

Also, there is also one other factor which is included in the APT which is also known as company's book to market ratio. With such factor, the stock's return will be sensitive to risks posed by book to market ratios. In such factor, the return of stock will be sensitive to beta of difference of return between high book to market ratios and low book to market ratios. Therefore, such factor will be included in the model and only such factors will be modelled in the model which will be categorized under macroeconomic factors or investment styyle factors.

Also, the relationship between one factor and CAPM is that the stock's return will be determined being sensitive to downside risk of market. In other words, in one factor model too, the average investor will be sensitive to risk of market so that an average investor will be compensated by risk premium during the bad times.

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jeff jeffy answered 1 year ago

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