To Critically Compare the Arbitrage Pricing Theory with the Capital Asset Pricing Model

In: Business and Management

Submitted By ludan2010
Words 1561
Pages 7
Introduction
Managing portfolio and investing in stocks is very risky and could be tricky, as a result, financial experts and investors view it as necessary or smart to know what to expect when they invest. Due to this, different statistical models have emerged to attempt to scientifically measure the potential returns on an investment. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two of such models. The purpose of this essay is to critically compare the Arbitrage Pricing Theory with the Capital Asset Pricing Model as used by fund managers in the United Kingdom.

Captial Asset Pricing Model (CAPM)

When Sharpe (1964) and Lintner (1965) proposed the Capital Asset Pricing Model (CAPM), it was seen as a leading tool in measuring if an investment will yield in positive or negative returns. It attempts to explain the relationship between investment risk and expected reward of risky securities (Ushad, 2011; Reilly and Brown, 2011; Heshmat, 2012). The CAPM helps to determine the required rate of return for any risky asset (Reilly and Brown, 2011).
“The CAPM states that the expected return on a security or a portfolio equals the rate on a risk-free security plus a risk premium” (Heshmat, 2012: 504). It indicates that the expected return on an asset has a positive linear relationship with the non-diversifiable risk of the security (beta) (Heshmat, 2012). Ushad (2011) explains that the CAPM is based on the premise that higher returns should be associated with higher beta risks. It is usually calculated as follows: E(Ri)= Rf + βi (E(Rm) - Rf). (Ushad, 2011).
Where, E(Ri) = return required on financial asset i
Rf = risk-free rate of return βi = the sensitivity of the asset’s return to the market
E(Rm) = average return on the capital market

Sharpe (1964) and Lintner (1965) proposed various assumptions that the CAPM must take…...

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