The comparison of underlying assumptions and conclusions of the CAPM and the APT models Prepared by: Professor: Prague, 2013 Introduction This paper studies the characteristics and application of valuation models of financial assets CAMP and APT. The methodology of measuring financial assets emerged in the second half of the 20th century, the most effective in practice, are now pricing model of financial assets as a CAPM and its subsequent conversion APT. With the pricing model of APT it is possible to make more complete and qualitative analysis of selected assets, considering the impact on the price of non-market factors.
In the 1950s, Harry Markowitz developed the CAPM, or the Capital Asset Pricing Model. The point of this model is to demonstrate the close relationship between the rate of return on the risk of the financial instrument. The general idea of the APT The APT, or the Arbitrage Pricing Theory was born as an alternative to CAPM. Many are not satisfied with the assumptions that are made in the model of the CAPM, and in 1976, Yale University professor Stephen Ross developed his theory, built only on arbitrage arguments. In order to understand the APT, we have to know what is the arbitrage.
Arbitrage – the exploitation of security mispricing in such a way that risk-free economic profits may be earned. (Bodie, 1999) The theory is based on one of the main statement – the arbitrage on the equilibrium market is impossible (the market “quickly eliminate” this opportunity). The arbitrage pricing theory is based on a significantly smaller number of assumptions about the nature of the stock market than CAPM. The whole concept of arbitrage implies a guaranteed, risk-free profit from the game on the market.
To understand the arbitrage concept, assume the situation, when the shares of one company are listed on a various trading platforms and the current market price of the same shares in the markets are different. Then the obvious next steps: to make short selling of a certain number of shares at the market where the shares are worth more, and buy the same number of shares at a another market, where the shares are cheaper. Such possibility, really, does occur. As the numbers of participants in the stock market are huge, there is little hope that this possibility no one else could notice – will notice and begin to use.
However, the sudden increase in demand of one share is going to be expensive, and the price of another share will fall. In 1976, Stephen Ross stunned the world of finance with the arbitrage pricing theory. The arbitrage pricing theory is based upon the assumption that there are a few major macroeconomic factors that influence security returns. In other words the APT holds that: * The expected return from a security is a linear function of various factors affecting the returns from the securities in the market * These factors may be interest rate, inflation, currency rates, GDP growth, oil prices etc. each factor is represented by a factor is represented by a factor specific beta coefficient. Therefore, based on APT, the risky and profitable assets with the same extent should have the same cost. This model suggests the possibility of arbitration in the setup asset prices. (Bodie, 5th edition) Market investors seek to increase the portfolio return without increasing the risk. This possibility can be realized through the arbitration portfolio. This operation will allow the investor get a risk-free income. The attractiveness of using the arbitrage pricing theory is determined by its multifactor.
In practice it is rarely possible to describe the movement of the market according to only one factor. The price of shares, and hence its earnings are affected by several factors. The choice of factors becomes purely subjective procedure and should be determined by the investor. That is why large institutional investors do not very widely use this theory in their practice. Despite the difficulties, the arbitration theory still used in practice and very successfully. The general idea of the CAPM The capital asset pricing model is a set of predictions concerning equilibrium expected returns on risky assets.
Harry Markowitz laid down the foundation of modern portfolio management in 1952. The CAPM was developed 12 years later in articles by William Sharpe, John Lintner, and Jan Mossin. (Bodie, Investments, 1999) The point of this model is to demonstrate the close relationship between the rate of return on the risk of the financial instrument. All we know, that the greater the risk, the greater the yield. Therefore, if we know the potential risk of a security, we can predict the rate of return. Conversely, if we know the rate of return, then we can calculate the risk.
All calculations of this kind for the return and risk are carried out using the capital asset pricing model. The model has become very popular after the release and to this day remains one of the main tools of valuation of shares. This popularity is due to the simplicity of the model and the intuitive idea of how to involve risk and return of the security. Briefly, the capital asset pricing model helps to determine what return the investor deserve for putting his or her money at risk. The assumptions of both frameworks The APT model was created as an alternative to the CAPM.
As the CAPM, this model accommodates implications for the relationship between expected returns and risk on securities. The APT model has differences from CAPM in its assumptions and in the way that equilibrium prices are reached. As the CAPM, the APT assumes that investors are completely diversified. Also, the systematic risk is an important factor in the long-term period because the systematic risk is significant in determining the expected return. The APT depends on the assumption that a rational equilibrium in capital market precludes arbitrage opportunities.
The APT yields an expected return-beta relationship using a well-diversified portfolio that practically can be constructed from a large number of securities. (Bodie, Investments, 1999) The CAPM is criticized as being unrealistic. However, it works and has been going very popular among investors for more than 40 years. The CAMP considers only systematic risk of the investors’ portfolio, because unsystematic risk has been removed and can be removed. There are many doubts about the role of CAPM in a financial world.
However, the CAPM remains a very useful item in the finance. The conclusions of both frameworks Under the CAPM the beta coefficient is used. Classic view of the beta is to ensure that it characterizes the volatility of the investment tool, which is relative to market volatility. In this definition, there is a logic, which was proposed by Markowitz: large amplitude vibrations in his opinion, points about the greater unpredictability of prices. This axiom is attractive in its simplicity, because it turns out that the investment risks inherent in beta.
However, the behavior of stocks in the past does not say anything about its future risks. Beta would be effective only if it would be possible to go back and use the current value of beta for stock selection. The APT performs many of the same features as the CAPM. It provides us with a reference for the establishment of objective rate of return, which can be used to plan the long-term investment securities valuation or assessment of the investment efficiency. Conclusions CAPM brings considerable benefit in the case of long-term investment planning.
If the firm is considering a new project, the CAPM allows calculate the rate of return, which should provide a project to be acceptable for investors. Managers can use the CAPM in order to receive the Internal Rate of Return – IRR, or hurdle rate that is required for the approval of the investment project. APT is based on assumptions about the profitability of a securities with a number of unknown factors that securities or portfolios with the same sensitivity to the factors with the same behavior, and therefore should have the same expected returns.
APT was originally developed as an alternative to the CAPM for a well-diversified portfolio, but theoretically arbitrage conditions should apply to individual assets. We do not need so much APM as such, but those fundamental premises, which it opened, appearing in the back of the researchers. These conditions in many market intuitively organize the market of any goods and are a major emergent property of a market as a socio-economic system. Works Cited Bodie, K. M. 5th edition. Bodie, K. M. (1999). Investments.