Capital Asset Pricing Model (CAPM) vs.
Arbitrage Pricing Theory (APT)
Capital
Asset Pricing Model (CAPM)
Arbitrage
Pricing Theory (APT)
"The
APT is derived from the premises that asset returns follow a linear returns
generating process, and that in well-functioning financial markets, there will
be no arbitrage opportunities. On the basis of these assumptions, one can show
that there is an equilibrium linear relationship between the returns on risky
assets and a small set of economy-wide common factors. While several
macroeconomic variables do have some relationship with different risky assets,
the APT postulates that the pricing of risky assets depends only on the set of
variables whose influence is felt significantly by all risky assets together.
This set of variables is known as the common factors of the APT." (Otuteye)
Investing
in stocks is tricky. Betting on your perception of the public's perception of a
how a company will successfully fulfill their perception of a market need is
not easy. 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. They are
similar in that they attempt to measure an asset's propensity to follow the
overall market however APT attempts to divide market risk into smaller
component risk. Regardless, it is very difficult to predict which companies are
strategically positioned well into the
future in the right growing markets from a product, market-share, distribution,
and corporate culture standpoint. It is even harder if not impossible to
predict what the investor public's reaction would be to such a success if you
were to correctly envision it.
The
capital asset pricing model (CAPM) states that the return on a stock depends on
whether the stock's price follows prices in the market as a whole. CAPM is
useful because it is a statistical representation of past risk. In my opinion,
even though past performance is no guarantee for future success there is a higher
probability that a consistent past performer will continue to do well over a
new untested entry in the market.
Arbitrage
pricing theory (APT) holds that the expected return of a financial asset is
largely based on its "beta". Beta is the measure of the relationship
between company related factors which influence financial performance and the
overall market in which the latter competes. Typically a company which has a
beta of one will reflect the market whereas a beta score of 0.75 means that a
company will move up or down to the extent of 75 per cent of the corresponding
market movement.
"
Since
the common factors of the APT are not identified in the model they have to be
empirically determined. As well, it can be shown that the empirical specification
of the APT need is not unique.(f.7) In other words, no one set of economic
factors constitutes "the factors" of the APT." (Otuteye)
If
I had researched what I thought would be a large stable company that would
progressively expand over the next 10-20 years maybe I would use CAPM to
validate past shareholder value performance data but nothing more.
Arbitrage
Pricing Theory can be useful if one is investing in a company and wanted to
measure the historical share price sensitivity to huge market fluctuations
typical during the onset of bull and bear markets. Based on an investor’s
long-term and short-term goals different investment strategies could be planned
using APT as an exhibit. For example, if a company had a beta of one thereby
likely to follow the market an investor anticipating a recession would hold off
purchasing that stock if their goal was to invest their money for no longer
than a few years and vice versa.
Investing
in stocks is tricky. Betting on your perception of the public's perception of a
how a company will successfully fulfill their perception of a market need is
not easy. 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. They are
similar in that they attempt to measure an asset's propensity to follow the
overall market however APT attempts to divide market risk into smaller
component risk. Regardless, it is very difficult to predict which companies are
strategically positioned well into the
future in the right growing markets from a product, market-share, distribution,
and corporate culture standpoint. It is even harder if not impossible to
predict what the investor public's reaction would be to such a success if you
were to correctly envision it.
BIBLIOGRAPHY
I. Works Cited
Otuteye,
Eben.
The Arbitrage Pricing Dichotomy. Canadian Investment Review, 1998
The Economist. Risk and Return. The Economist, 1996
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Otuteye,
Eben.
The Arbitrage Pricing Dichotomy. Canadian Investment Review, 1998
The Economist. Risk and Return. The Economist, 1996
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