Question

Q-4: Hakim Khaliq is interested in evaluating two stocks – Stock Yalla and Stock Habibi. Hakim wants to

use two important theoretical models; capital asset pricing model and arbitrage pricing model. Describe

the main theoretical aspects of these two model and comment on their relative advantages and

disadvantages.

Answer 1

Capital Asset Pricing model: It is a theoretical method to measure return given by an asset at a certain risk level.

CAPM model used beta of the asset, risk free rate and risk premium which is market return over the risk free rate.

return on the asset = risk free rate + beta * ( market return - risk free rate)

Arbitrage Pricing Model: It is used as a alternative to the CAPM where theoretical rate of return is measure in equilibrium as aliner funtion of risk of assets, considering a certain set of systematic risk.

In case of CAPM there is only one risk factor i.e., beta but in APT there are many risk free factors which are defined by its respective betas.

retun on asset = risk free rate + beta of factor 1 * risk premium on factor 1 + beta of factor 2 * risk premium on factor 2 + .................. + beta of factor n * risk premium on factor n

Advantages of CAPM over APT:

1. Only one risk factor is considered in case of CAPM.

2. Easy to capture the risk of one factor thus easy to implement.

3. It is easier model than APM or APT.

Advantages of APT over CAPM:

1. It uses less assumption than CAPM.

2. Provided better result due to considering many risk factors.

3. It uses asset specific factor to measure return rather than market risk factor.