Advanced Finance Part I
Question 1 part A
Similarities between CAPM and APT is that
both models are used for the assessment of the theoretical rate of return on assets. They can also be used when the investment is on a portfolio of assets. Both models divide risk into systemic risk and non-systemic risk. The two models are linear, although CAPM uses one factor-beta and APT uses multiple factors, both models are linear in the form (Connor & Korajczyk, 1986; Fama & French, 2004).
Differences between CAPM and APT
According to Fama & French (2004), the theory of an equilibrium asset pricing that is used for showing that the rate of expected return equilibrium on all risky assets is their sameness functions with the market portfolio is called Asset Pricing Model (CAPM). The Capital Asset Pricing Model is a single index model that systematic risks are defines that concerns an extensive market portfolio. The CAPM uses the risk-free rate. Mainly uses the federal fund rate ten-year government bond yield. It incorporates the assets beta, expects a return, and investment risk to be able to convert the asset into an investment (Roll & Ross, 1980; Fama & French, 2004).
Rj = Rf + Bj(Rm – Rf)
Where;
Rj = asset or portfolio expected return
Rf = return risk-free rate
Rm = market expected return
Bj = asset vitality or portfolio to that of the market m.
An equilibrium asset theory that is acquired from a factor model by the usage of arbitrage and diversification is called Arbitrage Pricing Theory (APT). Risky asset expected return as a linear combination of several factors is shown by the APT (Connor & Korajczyk, 1986). More recently, based on this single factor CAPM, Fama and French (1993) came up with Fama-French three factors model. Furtherly, Carhart (1997) proposed a four-factor model adding momentum factor based on three factors, and Fama and French (2015) developed the Fama-French five factors model. Those asset pricing theories models are broadly employed in seeking excess return and abnormal return. Asset pricing model’s factors are grouped as market factors, such as liquidity factors (Amihud, 2002), information factor (Jiang et al., 2005); fundamental factors for instance: quality factors and investment factors Hou et al. (2015), and economic factors GDP factors (Nguyen et al., 2009).
That is, assets riskiness is asserted by APT and, therefore, its sensitivities to particular factors is directly proportional to its average long-term return. Therefore, the APT is a multi-factor model that several factors are allowed because it is essential in assets pricing; the model itself does not define the variable. Not like CAPM, whereby only one unchanging factor is recognized, over time, the critical factors in APT change.
Rj = Rf + Bj1(RF1 – Rf) + … + Bjk(RFk – Rf)
Rj = asset return
Rf = return risk free rate
Bj = asset sensitivity to a certain factor
RFk = portfolio expected return with an average (1.0) sensitivity to a factor k
j = asset
k = factor
Both models have their origin. CAPM was designed in 1960, while APT was in place in 1975. Thus it can be eluded that APT is an advance of CAPM from one factor too many. With CAPM, the level of risk is known; therefore, APT was brought forth as a linear estimation to be able to accurately assess the market risk (Connor & Korajczyk, 1986).
The underlying assumption that arbitrage pricing and capital asset pricing model have many differences. In a nutshell, there are many assumptions with the capital pricing model, and when many assumptions are met, the expression of the resulting model is clear and simple. The pricing model assumptions are generally simple, and the mathematical expressions it derives are much complex, and it can be recognized from the much parameters that estimation is needed. Expressly, the assumptions made in the capital asset pricing model regarding the investor’s type and investor expectations in the investment period are not stated in the arbitrage pricing model.there are different assumption about investors type in arbitrage pricing and capital asset model. The investors are risk-averse is assumed by former model; investors’ preference for risk is not specified in the latter. This shows that there is a considerable increase in the investor’s base and arbitrage pricing model.
There are different manifestation and scope of systematic risk. In CAPM model the systemic risk is referred to as a market risk comprehensive reflection that is, in the overall market return rate impact changes on the yield of securities, measured by the sensitivity coefficient of changes in the yield of safety relative the market portfolio return changes. The market risk is used by the CAPM to represent a systemic risk for the analysis of the reciprocal connection between the expected return of securities and the systemic risk. Still, there is no further elaboration of the particular triggers of the systemic risk. As an extension of CAPM, APM fills up this gap to a substantial extent—the systemic risk is divided into k systemic factors in consonance with diverse risk source. Types of factors are not restricted, thereby the scope of factor contemplation is expanded. Market risks cannot only be included in the systemic factors.
The application range of the two models is different. According to Fama & French (2004), the asset sensitivity to the market changes is only looked by CAPM, while APT will looks at a wide range of factors running from macro to industry-specific factors. Through the capital asset pricing model, comparative analysis and the arbitrage pricing model. More so, with the differences between the two models analysis, we can know that the accurateness of the capital cost, the application of the capital asset pricing model can be made to various enterprises. Enterprises with requirements that are low and weaker managers’ abilities to calculate risk value independently for those companies that require high perfection in the capital cost amount can use arbitrage pricing model. Due to the complexity of the theory, it makes it only applicable to larger companies that can do the measurement of their specific risk values and risk factors.
Strengths and weaknesses of the models
It is important to note that although APT is seen to be more accurate, it is tedious and requires a lot of time to arrive at the factors to be used and make estimations. Thus it is not appropriate for argent decision making (Roll & Ross, 1980). Therefore, it is most suitable for long-term investments that have longer timelines to arriving at a decision. On the other hand, CAPM is most appropriate when time is limited. Also, at times it is difficult to determine the factors that are right or even get the correct data to do the APT model; in this case, the CAPM is preferred (Connor & Korajczyk, 1986).
Therefore, CAPM’s main strength lies in its simplicity. This makes it more preferred since it is easy to use and arrive at a decision. As for APT, its significant strengths lie in its level of accuracy, which is relatively high as it can impose more factors. Thus since APT is multiple factor models, it is an advanced form of CAPM. The major weakness of CAPM is its inability to encompass other factors comprising reliability.