Strengths Of The Capital Asset Pricing Model And Arbitrage Pricing Model
Discuss the strengths and weaknesses of the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) model as practical methods of asset pricing.
Introduction:
The Capital Asset Pricing Model known as (CAPM) and the Arbitrage Pricing Theory (APT) are two of the most used and important equilibrium pricing models known to investors and portfolio managers. They are both used for the same reasons to find out certain characteristics about stocks, assets, and portfolios. Although they have different assumptions regarding the market and investors capabilities, they are still both highly-regarded methods to find asset prices. Therefore, in this essay, I will discuss the strengths and weaknesses of the Capital Asset Pricing Model and the Arbitrage Pricing Theory to distinguish how practical they are as methods of asset pricing.
Weaknesses of the Capital Asset Pricing Model:
The Capital Asset Pricing Model has quite a few disadvantages when it comes to asset pricing. First, to calculate the CAPM, values need to be allocated to the variables which include; the risk-free rate of return, return on the market or equity risk premium known as the (ERP) and the Equity Beta. (Accaglobal.com, 2018). ‘This creates problems as finding a value for the ERP is more difficult.’ The CAPM is calculating the expected return of an asset using this equation: r ̅_a=r_f+β_a (r ̅_m-r_f). Where: r_f= Risk-free rate, β_a= Beta of the security and r ̅_m= Expected Market Return. The CAPM has
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