Question

The arbitrage pricing model (APT) is a multi-risk factored asset pricing model that allows more than one risk factor to influence security prices”. In term of this statement, critically discuss the assumptions of the APT, its criticisms and its advantage over the CAPM. (In your answer provide a brief discussion on some of the common risk-factors used in APT).Subject is INVESTMENT

Answer 1

Arbitrage pricing theory is often considered as a better version of Capital Asset pricing model because it will be including more than one risk factor to influence the security prices.

Assumptions of arbitrage pricing theory are as follows-

A. Asset returns are explained by the systematic factors

B.there would not be any arbitrage opportunity existing between well diversified portfolio

C. There are no restriction on short selling of any of the assets.

D. Investors have homogeneous beliefs and they are risk averse.

Advantages of arbitrage pricing theory is as follows-

A. It would be including multiple risk factors in calculation of the overall returns and it would be adjusting the beta of the company related to those factors.

B. It is often considered a better model than Capital Asset pricing model

Disadvantages of arbitrage pricing theory as follows-

A. These are not generally easy to implement.

B. It is used lesser than Capital Asset pricing model because it is highly complex in nature  

Overall it can be concluded that these arbitrage pricing theory models will be adjusting the beta of the company to non company factors like market risk and other demand fluctuations along with political risk and quantifies risk.