CAPM VS APT
INTRODUCTION
Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are used to determine the theoretical rate of return on an asset or portfolio of assets. CAPM was developed in the 1960s by Jack Treynor, William F. Sharpe, John Lintner, and Jan Mossin while APT was developed in 1976 by Stephen Ross as an alternative for CAPM. ( NICKOLAS )
CAPM
This shows the relationship between market risk and expected return or describes the relationship between the expected rate of return.
Ra = Rf + β(Rm - Rf )
where;
Ra is the asset price.
Rf is the risk-free rate
Rm is the expected market return
β is the measure of stock risk (measure fluctuations of stock price/volatility).
CAPM can be used in the calculation of the Weighted Average Cost of Capital (WACC) to calculate the Cost of Equity (Re) . It is also used as a discounting factor to calculate the Net Present Value of an asset (NPV).
APT
APT states that there is a linear relationship between the assets expected return and the macroeconomic factors associated with its risks. This means we can use linear regression analysis to predict/forecast the asset return given the asset’s expected return and factors affecting the risk of the asset. Here investors choose their own risk portfolio and expected returns based on the asset returns. This model helps investors determine the theoretical fair market value of an underlying asset.
ER(x) = Rf + β1Rp1 + β2Rp2+ ……….+βnRpn
where
ER(x) is the asset price.
Rf is the risk-free rate
Rp1 is the expected market return of the risk factor one
β1 is the measure of stock risk (a measure of fluctuations of stock price/volatility) of the risk factor 1.
DIFFERENCES BETWEEN CAPM AND APT
WHAT MODEL TO CHOOSE BETWEEN CAPM AND APT
While both models are used to price an asset, one model is more relevant and practical when pricing an asset at a given time. Choosing which model to use can be determined by a number of factors. These factors include;
1. Level of risk as the main determinant of pricing the asset.
2. Duration for pricing the asset.
3. Accuracy of the Price
4. Access To Time and Relevant Variables.
Level Of Risk As The Main Determinant Of Pricing The Asset.
There are many factors that make an investment in an asset risky. Some of these factors could be macroeconomic or company-specific. These factors are very relevant and important when pricing an asset and should be included.
In the CAPM model, the expected return of an asset is a linear function of market risk, while in APT model, the expected return of an asset is a linear function of numerous unknown risk factors. (Lekovic, and Stanisic) . This makes the APT model more reliable and practical in this case.
Is It A Single Asset or A Portfolio?
For a single asset, accuracy is the priority.(Corbett). From the discussion above on the differences between CAPM and APT, APT is more accurate since it considers multiple factors and it is an extension of CAPM.
“ For a portfolio, the inaccuracy of CAPM on individual assets may be less of a problem than the multiple calculations and models required of APT.” Corbett
Accuracy Of The Price.
APT has proven to be more accurate than and gives more reliable results as compared to CAPM. ( Samarakoon )
Access To Time and Relevant Variables.
Since APT takes into account multiple factors, if you have access to relevant information on the factors then use them to construct an APT model which can be used to price an asset. Additionally, the time you need to make the decision should be long enough to allow for the construction of the model and pricing of the asset since APT requires you to determine the variables and then calculate the sensitivities for all of them.
CONCLUSION
For single assets, APT should be favoured while a portfolio can use CAPM on individual assets to avoid multiple calculations. CAPM is relatively easy to calculate so computing it first, and evaluating if it is good is a good starting point then you can continue to evaluate the APT. CAPM and the APT model are complementary models that complete each other.
REFERENCES
1. NICKOLAS, STEVEN. “CAPM Vs. Arbitrage Pricing Theory: What’s The Difference?”. Investopedia , 2019.
3. Corbett, Aidan. “CAPM Vs APT. Which One Is Right For You? | Kubicle Blog”. Kubicle.Com , 2018.
