The Capital Asset Pricing Model and the Arbitrage

Pricing Model: A critical Review

Dr. Monirul Alam Hossain
Associate Professor,
E-mail: monirulhossain@yahoo.com

The Capital Asset Pricing Model and the Arbitrage
Pricing Model: A critical Review

Introduction

When security prices fully reflect all available information, the capital markets are said to be
efficient. In the efficient capital market, security prices adjust very rapidly to new information.
The risk of a portfolio of a security depends not only on the standards deviations but also on the
correlation of possible returns (Van Horne, 1989). The capital market line (CMI) expression
deals with the expected return on efficient portfolio investment.

The capital Assets Pricing Model (CAPM) is developed by W.F. Sharpe in 1964. The CAPM is
the basis of modern portfolio theory. The CAPM is a model for determining the required rate of
return on an asset, taking into the risk of the asset. The CAPM is an equilibrium theory of how to
price and measure risk, where beta (), the measure of risk is at the heart of the CAPM. The
significant contribution of the CAPM is provides a measure of risk of an individual security
which is consistent with the portfolio theory (Weston and Copeland, 1986). It enables us to
estimate the undiversifiable risk of a well-diversified portfolio (Weston and Copeland, 1986).

Most probably, the most important challenge to the CAPM is the Arbitrage Pricing Theory
9APT). This theory is developed by Stephen R. Ross in 1976. The APT is a theory of asset
pricing in which the risk premium is based on specified set of risk factors in addition to or other
than correlation with the expected excess return on market portfolio. The APT is based on the
idea that in competitive financial markets, arbitrage will ensure that riskless assets provide the
same expected return (Van Horne, 1989).

The CAPM and the APT are the theories of how risky assets are priced in market equilibrium.
Both the models provide decision makers with estimates of the required rate of return on risky
securities. However, both the theories differ from each other in many respects. This article is an
attempt to draw contrast and compare between the CAPM and the APT with special reference to
their assumptions, implications and practical usefulness.

Assumptions of the CAPM and the APT

The assumption of the CAPM relating to market, investors and assets are as follows:

1. Assumption about the market-

a. There are no taxes and no transaction costs-cost of buying and selling.
b. Information is costless and simultaneously freely available to all investors.
c. There are many buyers and sellers in the market; so that none can influence security
prices.




2. Assumptions about investors-

a. Investors are risk adverse individuals. It is a one period model. Asset returns are defined
to be over the next period, and the investors are assumed to be maximizing their returns
over a single period (Emmery and Finnerty, 1991).
b. Investors have homogeneous expectation about asset returns in the future.

3. Assumptions about assets-

a. There exists a risk-free asset such that investors may borrow or lend unlimited amounts at
the risk-free rate.
b. The quantities of assets are fixed and all assets are marketable and perfectly divisible.

The assumptions of the APT are as follows (John Wei, 1988):

1. All investors exhibit homogeneous expectations that the stochastic properties of capital assets
return are consistent with a linear structure of K factors.

2. Either there are no arbitrage opportunities in the capital markets or the capital markets are in
competitive equilibrium.

3. The number of securities in the economy is either infinite or so large that the theory of large
numbers are applied.

4. The APT hold in both the multi-period and single period cases.

Both the CAPM and the APT are built on the principle of capital market efficiency. Therefore
both the theories posses the assumptions of capital market efficiency. In the case of the CAPM, it
considers only single period. On the other hand, the APT considers both multi-period and single
period cases. Though consistent with every conceivable prescriptions for the portfolio
diversification, no particular portfolio plays a role in the APT (Roll and Ross, 1980). Unlike the
CAPM, there is no requirement that market portfolio on mean variance efficient. Both the
theories hold that all investors have homogeneous expectations to maximize their returns. In
case of the APT, the law of large numbers are used for infinite or large number of securities. But
in case of the CAPM, it is used for an accurate approximation of the market portfolio.

Implications of the CAPM and the APT

The CAPM does try to explain the underlying causes of securities, whereas the APT does not.
The CAPM is a single factor model: expected return is determined by a single factor systematic
risk or beta; whereas the APT is a muli-factor model: expected return is determined by more than
one single factor (Lumby, 1980). For the empirical test of the APT, a variety of factors have
emerged as possible determinants of actual common security returns and as statistical tool or
method called factor analysis has been used to attempt to identify the relevant factors (Emmery
and Finnerty, 1991). But the APT does not say what the factors are or why they are economically
or behaviorally relevant. The APT simply implies that there is a relationship between security
returns and a limited number of factors (Van Horne, 1989). However, these factors cannot be
identified easily.

The APT is derived in a completely different way. However, it looks like to the CAPM, except
that it has got multiple beta factors. In the CAPM, each assets estimated by regressing its return
on the market portfolio return. On the other hand, the APT does not allow us to simply an assets
return against arbitrarily determined factors (Weston and Copeland, 1986). Instead, factor
analysis must be employed to extract the fundamental factors underlying all security returns.

The APT states that, if there are sufficient securities, it must be possible to construct a diversified
portfolio that has zero senility to each factor. Such a portfolio would be effectively risk-free and
therefore it should offer a zero risk premium. According to the APT, securities risk premium
depends upon two things- the risk premiums associated with each other and the securities
sensitivity to each of the factors (Brealy and Myers, 1981). But in case of the CAPM, the risk
premium is determined by the product of the market price of risk and the securities systematic
(undiversitiable) risk level. This later value is given by the product of the securities total risk
and the degree to which the returns on securities are correlated to the returns on the market
portfolio. But, if the expected risk premium of each of the portfolios is proportional to the
portfolios market risk, then the CAPM and the APT are equivalent (Brealy and Myers, 1981).
The APT is very similar to the CAPM in the sense that the expected return of any security is
equilibrium will be equal to the risk free rate plus a risk premium. Not only that, the APT is
similar to the CAPM in the application of the, model that it can be used in exactly the same way
as the CAPM for determining the cost of capital, for valuation and for capital budgeting (Weston
and Copeland, 1986).

The Practical Usefulness of the CAPM and the APT

The significant contribution of CAPM is that it provides a measure of the risk of an individual
security which is consistent with portfolio theory. It enables us to estimate the undiversifiable
risk of a single asset and compare it with the undiversifiable risk of a well diversified portfolio
(Weston and Compland, 1986). Practical use of the CAPM requires that estimate of beta for
securities should be reliable. It estimates the beta based on historical data are unrelated to actual
risk, now or in future, then the CAPM is not a good tool for decision making (Weston and
Copeland, 1986). In case of the CAPM, it is very difficult to estimate an accurate beta, because
betas tend to change overtime. In addition, the CAPM stresses one-dimensional measure of risk
(beta).

Despite the theoretical debate and the difficulty in obtaining accurate betas, some investors use
the CAPM, because it systematically relates return with risk and shows how key variables
interact (Cooley and Roden, 1986). In any event, the CAPM provides us with an understanding
of the investiors behaviour and market dynamics (Cooley and Roden, 1986). The CAPM is
useful in that it provides several significant views into the major factors of security price
determination, and so it is of direct interest of the decision makers within corporations. Although
it involves some unrealistic assumptions and it is not perfect and complete representation of the
real would, it is reasonably adequate (Lumby, 1980). The CAPM may not be perfect, but it does
appear to give a reasonable approximation of the world and it does have predictive ability. For
example, high beta securities tend to be more volatile and produce a higher expected return than
low beta securities.

One of the great advantage of the CAPM is its simplicity. But to test the CAPM two problems
arise. Firstly, the CAPM is concerned with expected returns and secondly, the market portfolio
should include all risky investment, whereas most of the market indexes contain only a sample of
common stocks (Brealy and Myers, 1981).

There is a debate about how much improvement can be obtained using the APT rather than the
CAPM. The study of Roll and Ross (1980) claimed that the APT is amenable to empirical
testing, in a way that the CAPM is no because (i) it is not necessary to test the returns on all
assets, nor (ii) there is any special role for the market portfolio. The studies of Chen (1983) and
Roll and Ross (1983) seem to suggest that the APT is an improvement over the CAPM, specially
when security returns contain some CAPM anomaly. Other studies (e.g., Brown and Weinstein,
1983) of portfolio performance find no significant differences between the APT and the CAPM.
Whether the APT should replace the CAPM is subject to much debate. Enough research is
required for the determination of whether the APT would replace the CAPM nor not. However, it
could be well that the APT will become the principal theory of asset pricing, with the CAPM as a
subject of it (Van Horne, 1989).

Conclusion

The CAPM and the APT are built on the principle of capital market efficiency. Both the models
state how risky assets are priced in the market equilibrium and they provide decision makers
with estimates of required rate of return on risky securities. In spite of their similarities, they
differ from various corners in relation to their assumptions, implications, practical use and the
like. The CAPM considers one factor the return is determined by a single factor, the securities
beta value. Therefore, the CAPM is often referred to as a single-factor model. The APT is called
as multi-factor variable and it is derived in a completely different way from the CAPM.

The APT emphasizes the role of the co-variance between asset returns and the exogenous
factors, while the CAPM stresses on the co-variance between asset returns and the endogenous
market portfolio (John Wei, 1988). The CAPM is a one period model, whereas the APT holds in
both the multi-period cases. The CAPM tries to explain the underlying causes of security returns,
whereas the APT does not. Certain studies find that the APT has better explanatory power of
security returns than does the CAPM. On the other hand, some other studies of portfolio
performance find no significant differences between the APT and the CAPM. Whether the APT
should displace the CAPM is a subject of much debate. More empirical research is needed in this
respect.

Bibliography

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Cooly, P.L and Roden, P. F (1988) Business Financial Management, Holt, Rinehart and
Winston.

Emery, R.D and Finnerty (1991) Principles of Finance with Corporate. Applications. West
Publishing Co.

Firth, M and Keane, S.M (1986) Issues in Finance. Philip Allan.

John Wei, K. C (1988) An Asset-pricing Theory unifying the CAPM and APT, The Journal of
Finance, September, pp. 881-895.

Roll, R and Ross, S.A (1980) An Empirical Investigation of the Arbitrage Pricing Theory, The
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