Asset Pricing Theory Vs Capm Analysis

1.0

ARBITRAGE PRICING THEORY (APT)

The Asset Pricing Theory is an approach to determining asset values based on law of one price and no arbitrage.

Founded upon the work of Ross (1976, 1977), it aims to analyze the equilibrium relationship between assets’ risk and expected return just as the CAPM does. The two key CAPM assumptions of perfectly competitive and efficient markets and homogeneous expectations are maintained. Moreover, in line with the CAPM, the APT assumes that portfolios are sufficiently diversified, so that the contribution to the total portfolio risk of assets’ unique (unsystematic) risk is approximately zero.

The APT’s two main differences from the CAPM are:

a) The explicit modeling of several factors affecting assets’

CAPM assumes normal distribution.

b) The APT makes no strong assumption about individuals’ utility functions (at least nothing stronger than greed and risk aversion).

c) The APT allows the equilibrium returns of asset to be dependent on many factors, not just one (the beta).

d) The APT yields a statement about the relative pricing of any subset of assets; hence one need not measure the entire universe of assets in order to test the theory.

e) There is no special role for the market portfolio in the APT, whereas the CAPM requires that the market portfolio be efficient.

f) The APT is easily extended to a multi-period framework.

APT is seen as a multi-index (multi-factor) model, i.e. one in which the returns generating process of the portfolio is a function of several factors, generally excluding the market portfolio

Possible factors may include particular sector-specific influences, such as price-dividend ratios, as well as aggregate macroeconomic variables such as inflation and interest rate spreads. The covariance of each factor with the portfolio then leads to a natural extension of measuring risk by the beta attached to each

The risk free rate is 8%, the required rate of return on a portfolio with unit sensitivity to inflation and zero-sensitivity to other factors is 13.0%, the required rate of return on a portfolio with unit sensitivity to industrial production and zero sensitivity to inflation and other factors is 10% and the required return on a portfolio with unit sensitivity to the degree of risk aversion and zero sensitivity to other factors is 6%. Security i has betas of 0.9 with the inflation portfolio, 1.2 with the industrial production and-0.7 with risk bearing portfolio—(risk aversion)

Assume also that required rate of return on the market is 15% and stock i has CAPM beta of 1.1

Required:

Compute security i 's required rate of return using

a. CAPM

b. APT

4.0 CONCLUSION

Investors differ in their willingness to accept risk for a greater return. But if investors are willing to invest in the stock market, then they are willing to assume some risk. What the capital asset pricing model provides is a consistent means to price risk premiums. If you are willing to accept higher risks to get higher returns, then it makes sense to demand a higher return for a higher risk; otherwise, why take the higher risk. By comparing the beta of a stock and its historical return with that of the general market, you can determine whether the return of a stock is worth its