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Financial experts, shareholders and also for the investors must always be aware of the returns to expect from the stocks in which they invest. Many statistical models are available that are comparable to different values on that are based on the yearly yield, so as to facilitate the investors to decide upon the values in a more prudent manner. CAPM and APT are two such assessment tools. Before we try to discover the differences between CAPM and APT, let us take a closer look at both theories.
A a result of its ability to fairly assess the pricing of the different stocks in the market, Arbitrage Pricing Theory or APT has gained a lot of popularity among the investors. The fundamental assumption of APT is that the value of a stock is determined by a number of factors that include several macro factors as well as those that are specific to a company. First there are macro factors that are applicable to all companies and then there are the company specific factors. The following equation is employed to find the expected rate of return of a stock.
r= rf+ b1f1 + b2f2 + b3f3 + …..
Here r is the expected return on security, f is a number of factors affecting the price of security and b is the measure of relationship between security price and factor.
In an interesting way, the same formula is used to calculate the rate of return in case of CAPM too, which is also known as the Capital Asset Pricing Model. But, the difference is in the way a single non-company factor and a single measure correlation are used among price of asset and the factor in case of CAPM while there are numerous aspects and diverse measures of relationships between asset price and various factors in APT.
In APT, the performance of capital is to be considered independent of the market and its price is assumed to be driven by the company and non company specific factors. But, a disadvantage of APT is that no test can discover these factors and in fact one has to find empirically if factors of each company in which he is interested in finding the binding price. More number of factors identified, the more complicated becomes the task of finding different measures of relationships with different factors as well. These are the reasons why CAPM is preferred by investors as well as financial experts.Type your answer here...
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Advantages and limitations of arbitrage pricing theory?
The APT has a number of benefits. First, it is not as a restrictive as the CAPM in its requirement about individual portfolios. It is also less restrictive with respect to the information structure it allows. The APT is a world of arbitrageurs and vendors of information. It also allows multiple sources of risk, indeed these provide an explanation of what moves stock returns. The benefits also come with drawbacks. The APT demands that investors perceive the risk sources, and that they can reasonably estimate factor sensitivities. In fact, even professionals and academics can't agree on the identity of the risk factors, and the more betas you have to estimate, the more statistical noise you must live with.
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