Differentiate between Arbitrage Pricing and Capital Asset Pricing Theory

Overall, the APT model is designed for efficiency and works to estimate the rate of return of risky assets. The rate of return using the APT model can come in handy in terms of assessing whether or not stocks are priced appropriately. But in many instances, you can find similar outcomes using the CAPM model, which is comparatively simpler. Theoretically speaking, CAPM or APT analysis may lead to lower risk as investors use set mathematical formulae.

Even as CAPM and APT help assess market risks, they both remain static and rely on too few factors to forecast risk in an extremely complicated market. They may use mathematical principles to work, but they are still basically subjective. The analyst behind the calculation can use whatever factors they feel apply to every case. This seems conflicting, considering the most successful investors are probably those who can appreciate largely unseen potential in the market. Investors who adopt the same outlook can create a bubble that minimizes the asset’s inherent risks once asset price increases. In this case, measuring an asset’s risk according to the market’s temperament can be riskier than using CAPM or APT.

While both APT and CAPM offer valuable insights, they also have their limitations. CAPM’s assumption of a perfectly efficient market may not hold in reality, as markets can be influenced by various inefficiencies and behavioral biases. Additionally, CAPM’s reliance on historical data for estimating beta coefficients may not accurately capture future market conditions.

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Both APT and CAPM employ factor analysis to determine the expected returns of assets. CAPM focuses on a single factor, the market risk, which is represented by the beta coefficient. On the other hand, APT considers multiple factors that can influence asset returns, such as interest rates, inflation, industry-specific factors, and macroeconomic variables. APT allows for a more comprehensive analysis of the factors affecting asset prices.

APT, although more flexible, requires the identification and estimation of relevant factors, which can be challenging and subjective. It also assumes that the relationship between factors and asset returns is linear, which may not always be the case. CAPM assumes that the market is perfectly efficient, meaning that all relevant information is reflected in the prices of assets. It also assumes that investors are rational and risk-averse, seeking to maximize their utility. On the other hand, APT assumes that multiple factors influence asset returns, and these factors are not necessarily related to the market.

Assumptions

Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. The theory assumes an asset’s return is dependent on various macroeconomic, market and security-specific factors. At first glance, the CAPM and APT formulas look identical, but the CAPM has only one factor and one beta. Conversely, the APT formula has multiple factors that include non-company factors, which requires the asset’s beta in relation to each separate factor. However, the APT does not provide insight into what these factors could be, so users of the APT model must analytically determine relevant factors that might affect the asset’s returns.

Arbitrage Pricing Theory

• The theory assumes an asset’s return is dependent on various macroeconomic, market and security-specific factors.
• Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset.
• It also assumes that investors are rational and risk-averse, seeking to maximize their utility.
• They may use mathematical principles to work, but they are still basically subjective.
• On the other hand, APT assumes that multiple factors influence asset returns, and these factors are not necessarily related to the market.

In arbitrage, two transactions are carried out at the same time in two separate markets. However, typical changing market conditions may decrease profit immensely when they conduct CAPM evaluations. An asset’s or portfolio’s beta measures the theoretical volatility in relation to the overall market. For example, if a portfolio has a beta of 1.25 in relation to the Standard & Poor’s 500 Index (S&P 500), it is theoretically 25% more volatile than the S&P 500 Index. Still, both models are unrealistic in assuming that assets are unlimited in demand and availability, that you can get these assets for free, and that investors arrive at the same conclusions. Another drawback is that CAPM calculations are made for just one period, with the formula being too linear.

Differentiate between Arbitrage Pricing and Capital Asset Pricing Theory

It multiplies the risk-free rate by the asset’s beta coefficient and adds the market risk premium. This approach assumes a linear relationship between the asset’s risk and expected return. APT, on the other hand, employs a multi-factor model to estimate expected returns.

Thereafter, in 1976, economist Stephen Ross developed the arbitrage pricing theory (APT) as an alternative to the CAPM. APT (Arbitrage Pricing Theory) and CAPM (Capital Asset Pricing Model) are both widely used models in finance to estimate the expected return on an investment. CAPM assumes that the expected return of an asset is solely determined by its beta, which measures its sensitivity to market movements. On the other hand, APT takes into account multiple factors that can influence an asset’s return, such as interest rates, inflation, and industry-specific variables. The capital asset pricing model (CAPM) provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate.

• On the other hand, APT considers multiple factors that can influence asset returns, such as interest rates, inflation, industry-specific factors, and macroeconomic variables.
• CAPM assumes that the expected return of an asset is solely determined by its beta, which measures its sensitivity to market movements.
• In contrast, the APT formula has several, including non-company factors that call for the asset’s beta as per every independent factor.
• The APT does not offer information as to what these factors might be, though, which means APT users should examine all factors that could possibly impact the asset’s returns.
• Thereafter, in 1976, economist Stephen Ross developed the arbitrage pricing theory (APT) as an alternative to the CAPM.

On the other hand, the CAPM relies on the difference between the expected and the risk-free rate of return. APT is reliable for the medium to long term but is often inaccurate for short-term calculations. This gives it an advantage over CAPM simply because you do not difference between capm and apt have to create a similar portfolio for risk assessment. Risk is inevitable for all types of assets, but the risk level for assets can vary. Fortunately, even though no one can truly determine risk in an unpredictable market, there are ways to calculate the level of risk that comes naturally with a particular asset.

The risk-free rate of return that is used is typically the federal funds rate or the 10-year government bond yield. When it comes to investment analysis and portfolio management, two widely used models are the Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM). Both models aim to provide insights into the expected returns of assets, but they differ in their underlying assumptions and methodologies.

The biggest issue, though, is that calculations are not even consistent with empirical or actual results. Both are based on cost against the rate of return and have their own uses and downsides. The theorems are a bit complicated to understand at first, but taking your time with them will help you get an idea of how they are applied in real life. In short, the calculation is only as good as the professional who decides the factors that lead to the results.

The main problem with APT, however, is that it tries to accurately measure the risk for all assets. While you can determine a “factor portfolio” (reflecting very similar risks), the risk level is still essentially influenced by macroeconomic factors. The CAPM allows investors to quantify the expected return on an investment given the investment risk, risk-free rate of return, expected market return, and the beta of an asset or portfolio.