Its presumptions and simplicity have garnered criticism, nevertheless, which has prompted the creation of substitute models that take more elements into account. By include the size and value variables, the Fama-French Three-Factor Model, which will be discussed in the following section, increases the explanatory power of CAPM. The Fama-French model aims to remedy the shortcomings of CAPM and provide a more thorough explanation of asset returns by including these extra variables. The arbitrage pricing theory was developed by the economist Stephen Ross in 1976, as an alternative to the capital asset pricing model (CAPM).

Is It A Single Asset or A Portfolio?

CAPM calculates the expected return on an investment by using a single factor, which is the market risk premium. The market risk premium is the difference between the expected return on the market and the risk-free rate. On the other hand, APT uses multiple factors to calculate the expected return on an investment.

By contrast APT requires you to determine which variables are relevant to a particular asset, and then calculate the sensitivities for all of them. However, if you can manage this successfully, then APT is likely to give a more accurate and reliable result. The main difference is that while CAPM is a single-factor model, the APT is a multi-factor model. In the CAPM, the only factor considered to explain the changes in the security prices and returns is the market risk. In the CAPM model, the expected return of an asset is a linear function of market risk, while in APT model, the expected return of an asset is a linear function of numerous unknown risk factors.

Furthermore, because APT considers many more factors that influence security returns, it would have a greater predictive power in forecasting individual security returns than would CAPM. APT does not identify the risk factors to be included in the model. If the market risk is used as the only factor, the APT would equal CAPM.

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. 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. The APT along with the capital asset pricing model (CAPM) is one of two influential theories on asset pricing. The APT differs from the CAPM in that it is less restrictive in its assumptions, making it more flexible for use in a wider range of application. Thus, it possesses greator explanatory power (as opposed to statistical) for expected asset returns.

In two previous posts we have looked at these two models individually (CAPM here and APT here). In this post we’ll pit the two models against each other so you can identify which is more useful to you when you have an investment decision to make. A correctly priced asset here may be in fact a synthetic asset – a portfolio consisting of other correctly priced assets. This portfolio has the same exposure to each of the macroeconomic factors as the mispriced asset.

This means that APT provides a more nuanced approach to asset pricing by taking into account the sensitivity of a security to multiple factors. Although models for asset pricing like CAPM, the Fama-French models, and APT have greatly advanced our knowledge of the risk-return connection, they are not without flaws and restrictions. The use of historical data, the assumptions behind the models, the dependence on simplified risk metrics, and the assumptions relating to investor behaviour are all problems. However, current research tries to overcome these constraints by investigating other models, adding extra elements, and utilising technology developments. Researchers attempt to give more precise and comprehensive frameworks for comprehending and forecasting asset returns in actual financial markets by continuing to develop and refine asset pricing models. This model aims to take into account the impact of firm size and book-to-market ratio on predicted returns since it understands that the risk-return relationship cannot be entirely explained by a single element.

1. This means that APT provides a more nuanced approach to asset pricing by taking into account the sensitivity of a security to multiple factors.
2. Both the CAPM and the Fama-French models have the drawback of estimating risk premiums and factor sensitivity using past data.
3. I. Both models assert that there is a linear relationship between risk and return.II.
4. It can be difficult to fully execute the APT model in practise because market imperfections might lead to variations from the model’s theoretical predictions (Ross, 1977).
5. By include the size and value variables, the Fama-French Three-Factor Model, which will be discussed in the following section, increases the explanatory power of CAPM.
6. In this section, we will explore the key differences between these two models and discuss their respective advantages and disadvantages.
7. A fundamental asset pricing model that is frequently used in finance is the Capital Asset Pricing Model (CAPM), which was created by Sharpe and Lintner in 1964.

An example of the differences between CAPM and apt can be seen when considering the expected return on a stock. In this equation, E(Ri) stands for the anticipated return on asset i, Rf for the risk-free interest rate, i for the asset’s beta, Rm for the anticipated market return, and Rm – Rf for the market risk premium. A clear and easy framework for comprehending the risk-return connection is provided by CAPM. It makes the supposition that investors are logical, risk-averse, and possess uniform expectations.

1. The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are two of the most popular asset pricing models used by analysts and investors.
2. Empirical evidence suggests that the inclusion of these factors improves the model’s ability to explain the cross-section of asset returns.
3. In particular there are size effects and value effects which cause inaccuracies in CAPM for small stocks and value stocks.
4. That is, the expected return of an asset j is a linear function of the asset’s sensitivities to the n factors.
5. By examining empirical evidence and conducting a critical evaluation of these models we can gain insights into their practical applications and identify potential areas for improvement.
6. The main advantage of APT is that it allows investors to customize their research since it provides more data and it can suggest multiple sources of asset risks.

Arbitrage Pricing Theory

Investors need to be compensated for holding riskier assets, according to CAPM, in the form of greater expected returns. The market risk premium, or the difference between the projected market return and the risk-free rate, is used to measure this compensation (Fama, 1970). These models have made significant contributions to the world of finance and offer several viewpoints on how to comprehend the risk-return connection. They are also subject to criticisms and have limitations, which emphasise the need difference between capm and apt for continued study and improvement.

Assumptions of APT Model

APT, by contrast, requires more time and expertise from the analyst, both in determining which factors to include for each asset and in calculating the sensitivities for each of those factors. The CAPM only takes into account one factor—market risk—while the APT formula has multiple factors. And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks. Arbitrage is the practice whereby investors take advantage of slight variations in asset valuation from its fair price, to generate a profit. It is the realisation of a positive expected return from overvalued or undervalued securities in the inefficient market without any incremental risk and zero additional investments. Consequently, it’s vital to remember that the Fama-French model has several drawbacks.

It posits that the expected return of an asset is determined by its beta, which measures the sensitivities of the asset’s returns to the overall market returns. According to this model, the higher the risk levels of an asset ae relative to the market, the higher the expected returns should be. It assumes that investors are rational, risk-averse, and have homogenous expectations, and that all relevant information is reflected in stock prices (Fama, 1970).

Intuitively, the notion of one single factor explaining the return on any asset sounds unlikely, and it has generally proven to be this way. In particular there are size effects and value effects which cause inaccuracies in CAPM for small stocks and value stocks. Based on the discussion above, we can say that the APT will always be more accurate than CAPM, if the additional factors have any explanatory power. The issue is whether the accuracy gain is enough to merit the time and effort involved in deciding what factors to use, and gathering the relevant data. Both models have the same objective; identify the expected rate of return on an asset. In doing so, they allow the analyst to identify the price that the asset should have now and determine whether the asset is worth investing in.