Introduction
The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are two widely used models in financial management for determining the expected return on investments and assessing risks. While both models aim to price assets considering their risk, they are based on different assumptions and methodologies. This article explores the concepts of CAPM and APT, and highlights the key differences between them.
Capital Asset Pricing Model (CAPM)
CAPM is a model that determines the expected return on an investment based on its systematic risk (market risk). Developed by William Sharpe, John Lintner, and Jan Mossin, CAPM asserts that the expected return on a security is equal to the risk-free rate plus a risk premium.
Formula:
E(Ri) = Rf + βi [E(Rm) – Rf]
Where:
E(Ri) = Expected return of the security
Rf = Risk-free rate
βi = Beta of the security (sensitivity to market)
E(Rm) = Expected return of the market
Assumptions of CAPM:
- Investors are rational and risk-averse.
- Markets are efficient and free from transaction costs.
- All investors have the same expectations.
- Only systematic risk affects returns; unsystematic risk can be diversified away.
Arbitrage Pricing Theory (APT)
APT, developed by Stephen Ross, is a multifactor model that determines the expected return of a security based on various macroeconomic factors. Unlike CAPM, APT does not assume a single market factor but allows multiple sources of risk.
Formula:
E(Ri) = Rf + β1F1 + β2F2 + … + βnFn
Where:
Rf = Risk-free rate
βn = Sensitivity to factor n
Fn = Risk premium associated with factor n
Key Assumptions of APT:
- Markets are arbitrage-free.
- Returns are influenced by multiple factors (e.g., inflation, interest rates, GDP).
- Investors can construct portfolios to exploit arbitrage opportunities.
Difference Between CAPM and APT
| Aspect | CAPM | APT |
|---|---|---|
| Model Type | Single-factor | Multi-factor |
| Risk Factor | Market risk (beta) | Multiple macroeconomic risks |
| Assumptions | Strict market assumptions (perfect markets) | Fewer assumptions, allows arbitrage |
| Complexity | Relatively simple | More complex |
| Applicability | More theoretical | More flexible and practical |
Conclusion
Both CAPM and APT are important models for assessing expected returns and investment risk. CAPM provides a simplified view based on market risk, while APT offers a broader perspective incorporating various economic factors. Understanding the strengths and limitations of both helps investors and financial managers in making informed investment decisions.