In particular, capm only works when we make assumptions about preferences which dont make much sense. Arbitrage pricing theory capital asset pricing model. Capital asset pricing andarbitrage pricing theory prof. Espen eckbo 2011 basic assumptions the capm assumes homogeneous expectations and meanexpectations and meanvariance variance preferences. Pricing theory apt in explaining the relationship between risk and return. Unlike the welldocumented contribution of these models to understanding the relationship between return and risk and valuing assets on. The arbitrage pricing theory apt starts by assuming that actual returns are generated by a number of systematic factors a securitys risk is measured by its sensitivity to each of these factors from this we can derive an equilibrium relationship between expected return and risk. Arbitrage pricing theory stephen kinsella the arbitrage pricing theory, or apt, was developed to shore up some of the deficiences of capm we discussed in at the end of the last lecture. A comparative study of the arbitrage pricing theory apt and the capital asset pricing model capm was done in the indian scenario on the lines of the. Rather, the capm quantifies the expected rates of return of an asset with its relative level of market systematic risk beta. Pdf capital asset pricing model capm and arbitrage pricing theory apt have been a major challenge for economic theorists and. Of prasanna chandra limitations of capm the capm has been one of the most usefuland frequently used financial theories ever developed. The apt is a theory of asset pricing in which the risk premium is based on specified set of risk factors in addition to or other than correlation with the expected excess return on market portfolio.
Focusing on arbitrage pricing theory, this paper tries to analyze its effect in the indian stock market. Northholland publishing company a comparison of the apt and capm a note robert jarrow and andrew rudd corneu university, ithaca, ny 14853, usa received september 1982 the single factor version of ross arbitrage pricing theory and the sharpelintnermossin capital asset pricing model offer deceptively similar pricing relationships. Before we discuss the capm, it would be important to understand risk of portfolios. The capm, suggests that only nondiversifiable market risk influences expected security returns. Pdf we present a model of a financial market in which naive diversification. Capm relies on the historical data while apt is futuristic. The validity of capital asset pricing model capm and arbitrage pricing theory apt in predicting the return of stocks in indonesia stock exchange.
The capital asset pricing model and the arbitrage pricing theory can both be used to estimate a theoretical rate of return on an asset. The arbitrage pricing theory is an asset pricing theory that is derived from a factor model, using diversification and arbitrage arguments. Thus, the capm can be derived by assuming there is only a single linear risk factor and that this risk factor has the same risk as the market portfolio. Arbitrage pricing theory and the capital asset pricing model. The asset pricing theory predicts the relationship between a portfolios returns and a single assets returns with a linear combination of independent variables. The theory describes the relationship between expected returns on securities, given that there are no opportunities to create wealth through risk. Arbitrage pricing model financial definition of arbitrage. The apt implies that there are multiple risk factors that need to be taken into account when calculating riskadjusted performance or alpha. Capital asset pricing model, arbitrage pricing theory and portfolio management vinod kothari the capital asset pricing model capm is great in terms of its understanding of risk decomposition of risk into securityspecific risk and market risk. The capital asset pricing model and arbitrage pricing theory. Prices here are determined with reference to macroeconomic variables for the capm, the overall market. Assumptions individual investors are price takers singleperiod investment horizon investments are limited to traded. Both of them are based on the efficient market hypothesis, and are part of the modern portfolio theory. Further, we explore the arbitrage pricing model with datadriven examples provided using the famamacbeth regressions.
Apt stands for arbitrage pricing theory that has become very popular among investors because of its ability to make a fair assessment of pricing of different stocks. The capital asset pricing model capm and the arbitrage pricing theory apt have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. The advantages and disadvantages of the capm model i arbitrage pricing theory cfa level 1 this video is part of a bluebook academy course. The basic principle of the apt is that the payoff from each asset can be described as a weighted average of all assets in a portfolio. Pdf the arbitrage pricing theory approach to strategic. Its formal statement entails the following notation. Pdf the validity of capital asset pricing model capm and. Pdf the capitalassetpricing model and arbitrage pricing theory. This lecture covers the basics of the capital asset pricing model and looks into its derivation. The capital asset pricing model and the arbitrage pricing theory. The capitalassetpricing model and arbitrage pricing theory pnas. The advantages of arbitrage pricing theory apt over the capital asset pricing model capm single factor have been dealt with in this paper. Pros and cons of the capm model i arbitrage pricing theory.
Capm considers only single factor while apt considers multifactors. Furthermore, we exhibit the practical relevance and assumptions of these models. Capital asset pricing model and arbitrage pricing theory. Arbitrage pricing theory apt spells out the nature of these restrictions and it is to that theory that we now turn. In this study, we aim to evaluate stock returns using arbitrage pricing model considering four macroeconomic factors i. Capital asset pricing model capm and arbitrage pricing theory apt have been a major challenge for economic theorists and practitioners for decades. Arbitrage pricing theory assumptions explained hrf. Esuike school of economics, finance and banking university utara, malaysia. Financial economics arbitrage pricing theory theorem 2 arbitrage pricing theory in the exact factor model, the law of one price holds if only if the mean excess return is a linear combination of the beta coef. Arbitrage pricing theory the arbitrage pricing theory apt was developed by ross 1976 as a substitute for the capm. This theory, like capm, provides investors with an estimated required rate of return on risky securities. In finance, arbitrage pricing theory apt is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient.
Arbitrage pricing theory a pricing model that seeks to. The basic theory of the arbitrage pricing theory finance essay. Since its introduction by ross, it has been discussed, evaluated, and tested. Apt asset pricing model are very useful tools that enable financial annalists or just simply independent investors evaluate the risk in an specific investment and at the same time set a specific rate of return with respect the amount of risk of an. Portfolio theory and asset pricing models capital asset pricing model capm efficient frontier capital market line cml security slideshare uses cookies to improve functionality and performance, and to provide you with relevant advertising. Arbitrage pricing theory, often referred to as apt, was developed in the 1970s by stephen ross. Nwakanma prince c university of portharcourt, river state, nigeria faculty of management sciences, department of finance and banking. It is a oneperiod model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. Apt considers risk premium basis specified set of factors in addition to the correlation of the price of the asset with expected excess return on the market portfolio. The arbitrage pricing theory approach to strategic portfolio planning.
Comparing the arbitrage pricing theory and the capital asset pricing model there are inherent risks in holding any asset, and the capital asset pricing model capm and the arbitrage pricing model apm are both ways of calculating the cost of an asset and the rate of return which can be expected based on the risk level inherent in the asset. Capm, apt, empirical test, timeseries, regression analysis, beta coefficient, security market line, risk factors, factor loading. This distinction yields a valuation formula involving only the essential risk embodied in an assets return, where the overall risk can be decomposed into a. The theoretical limitations of using capm finance essay. Are practitioners and academics, therefore, moving away from capm. A short introduction to arbitrage pricing theory apt is the impressive creation of steve ross. Arbitrage pricing theory apt is an alternative to the capital asset pricing model capm for explaining returns of assets or portfolios. The capm lets investors quantify the expected return on investment given the risk, riskfree rate of return, expected market return, and the beta of an asset or portfolio. The model identifies the market portfolio as the only risk factor the apt makes no assumption about. Pdf capital asset pricing model versus arbitrage pricing. The arbitrage pricing theory apt was developed primarily by ross 1976a, 1976b. The arbitrage pricing theory apt differs from the singlefactor capital asset pricing model capm. Arbitrage pricing theory university at albany, suny.
The capitalassetpricing model and arbitrage pricing theory. Reconciling the arbitrage pricing theory apt and the capital 17 20532199 print, 20532202online asset pricing model capm institutional and theoretical framework ejuvbekpokpo stephen akpo, sallahuddin hassan and benjamin u. The cost of equity is defined as the expected return on an assets common stock in capital markets witmer and zorn, 2007. We examine the tradeoff between risk and return in real world applications founded on the premises behind the capm. Faculty of management sciences, department of accounting and finance. Before we try to find out the differences between apt and capm, let us take a closer look at the two theories. Pdf the capital asset pricing model and the arbitrage. Capm is more reliable as the probability may go wrong. This content was copied from view the original, and get the alreadycompleted solution here. The capital asset pricing model comes from a maximization problem of every. It is a much more general theory of the pricing of risky securities than the capm. After we compared the methods on the stock market, we choose to use the capm and the apt model on chinese stock market.
The arbitrage theory of capital asset pricing was developed by ross 9, 10, 1 l as an alternative to the meanvariance capital asset pricing model capm, whose main conclusion is that the market portfolio is mean variance efficient. Arbitrage pricing theory capital asset pricing model vs. Therefore, the capital assets pricing model capm and arbitrage pricing theory apt tried to quantify this rationality by modeling the. Arbitrage pricing theory apt is an alternate version of the capital asset pricing model capm. The capital asset pricing model capm, which can be used to evaluate alternative investments in order to determine if they are worthwhile or not from the perspective of the investors required rate of return has been much criticized because of some of its inherent problems and. Perspective on arbitrage pricing theory by chenoy ceil ssrn. Test of arbitrage pricing theory on the tehran stock. The capital asset pricing model capm is used in corporate finance to determine a theoretically appropriate price of an asset given that assets systematic riskor. Learn vocabulary, terms, and more with flashcards, games, and other study tools. Capm is simple and easy to calculate while apt is c. A comparison of the apt and capm a note sciencedirect. Practical applications of arbitrage pricing theory are as follows.
The two major theories on equilibrium pricing of securities are capital asset pricing model capm extended by sharp 1964, lintner 1965, mossin 1966 and black, jensen and scholes 1972 and the arbitrage pricing theory apt. The capital asset pricing model capm is the most widespread. The arbitrage pricing theory apt was proposed as a more complex and therefore more complete alternative to the capital asset pricing model capm which was thought to be too simple and limited. January 1990 june 2001 is weak, and the capital asset pricing model capm has poor overall explanatory power. Capital asset pricing model, arbitrage pricing theory and.
Capm or apt choose any one arbitrage pricing theory. Pdf capital asset pricing model versus arbitrage pricing theory. Let us now generalize the arbitrage pricing principle to the case of multiple risk factors and allow individual asset returns to have idiosyncratic components. It is considered to be an alternative to the capital asset pricing model as a method to explain the returns of portfolios or assets.
Arbitrage pricing theory gur huberman and zhenyu wang federal reserve bank of new york staff reports, no. Apt is an interesting alternative to the capm and mpt. The capitalassetpricing model and arbitrage pricing. Still, the model has some deficiencies some tests of capm indicated that the beta for individual securities were not stable, but portfolio betas were stable with some conditions. Difference between capm and apt compare the difference. Comparing the arbitrage pricing theory and the capital. An empirical test of factor likelihood arbitrage pricing theory in nigeria arewa, ajibola lagos state university, lagos, nigeria. Within the context of the capital asset pricing model capm assume expected return on the market 15%. Based on intuitively sensible ideas, it is an alluring new concept. The big difference between apt and capm is that capm only looks at the asset in comparison to market changes, whereas apt looks at multiple factors. What are the practical applications of arbitrage pricing. Our website is a unique platform where students can share their papers in a matter of giving an example of the work to be done. These models are born out of modern portfolio theory, with the capital asset pricing model capm as the prototypical result. G12 abstract focusing on capital asset returns governed by a factor structure, the arbitrage pricing theory apt is a oneperiod model, in which preclusion of arbitrage over static portfolios.
The arbitrage model was proposed as an alternative to the mean variance capital asset pricing model, introduced by sharpe, lintner, and treynor, that has become the major analytic tool for explaining phenomena observed in capital markets for risky assets. Arbitrage pricing theory apt is a general theory of asset pricing that holds that the expected return of a financial asset. Arbitrage pricing theory apt an alternative model to the capital asset pricing model developed by stephen ross and based purely on arbitrage arguments. The apt is based on the idea that in competitive financial markets. Arbitrage pricing theory takes into account more influencing factors other than the simple systematic risk, as defined in capm. When implemented correctly, it is the practice of being able to take. Money supply, interest rate, industrial production and foreign exchange rate. As a lot papers study on the main board of chinese stock market, we pay our attention on the sme board and the chinext board of chinese stock market. The capm lets investors quantify the expected return on investment given the risk, riskfree rate of return, expected market return. Thus, various asset pricing models can be used to determine equity returns. Rf 26 the capital asset pricing model and the arbitrage pricing theory the capm theory is really just a simplified version of the apt, whereby the only factor considered is the risk of a particular stock relative to the rest of the stock market as described by the stocks beta. The capital asset pricing model and the arbitrage pricing.
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