Under market efficiency, the expected return of an asset is solely a function of its systematic risk, with no room for arbitrage or mispricing. Capital Market Line vs. The CML is sometimes confused with the security market line (SML). While the CML shows the rates of return for a specific portfolio, the SML represents the market’s risk and return at a given time, and shows the expected returns of individual assets. However, the APT also has several limitations and challenges as a model for estimating the expected return of an asset. First, it is not a complete model, as it does not specify the number and nature of the factors, nor their risk premiums. Third, it may not be consistent with the equilibrium theory, as it does not account for the preferences and behavior of investors, nor the supply and demand of assets.

How investors, portfolio managers, and financial analysts can use CAPM and APT in their decision making?

By determining the exposure of an asset to each macroeconomic factor, APT helps investors understand how economic shifts can affect individual asset returns. Overall, the APT model is designed for efficiency and works to estimate the rate of return of risky assets. The rate of return using the APT model can come in handy in terms of assessing whether or not stocks are priced appropriately. Empirical tests have proven the APT formula is more reliable compared to CAPM. But in many instances, you can find similar outcomes using the CAPM model, which is comparatively simpler. APT is reliable for the medium to long term but is often inaccurate for short-term calculations.

Allocating Assets and Constructing Portfolios

On the other hand, it is not always possible to know the right factors or to find the right data, which is when CAPM may be preferred. An analyst determines the Rf, Rm, and βi figures, but investors usually use a beta figure provided by a third party. Analysts and investors use CAPM mostly to calculate an asset’s fair price during arbitrage. The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected difference between capm and apt return and risk of investing in a security. Some investors use the beta only to measure the risk while other investors use both beta and variance of returns as the sources of reward. As individuals have varying perceptions towards risk and reward, CAPM gives a series of efficient frontlines.

• Capital asset pricing model (CAPM) is widely used by investors to estimate the return or the moving behavior of the stock and Markowitz model is employed to achieve portfolio diversification.
• The theory allows for a more flexible framework since it doesn’t mandate that all investors hold the same portfolio.
• The APT implies that this relationship holds for all well-diversified portfolios, and for all but perhaps a few individual securities.
• The CAPM only takes into account one factor—market risk—while the APT formula has multiple factors.
• Watch this video to see an example of how investors use APT to their advantage.

CAPM vs. Arbitrage Pricing Theory: An Overview

Arbitrage Pricing Theory (APT) is an asset pricing model that determines the expected return of a financial asset based on multiple macroeconomic risk factors. Proposed by Stephen Ross in 1976, APT suggests that stock returns are influenced by factors such as inflation, interest rates, GDP growth, and market sentiment. Unlike CAPM, which relies on a single market risk factor (beta), APT allows for multiple systematic risks. Investors can exploit mispriced assets through arbitrage, ensuring that prices adjust to reflect fair value over time.

What is arbitrage pricing theory?

On the other hand, APT takes into account multiple factors that can influence an asset’s return, such as interest rates, inflation, and industry-specific variables. While CAPM is simpler to use and widely accepted, APT provides a more comprehensive and flexible framework for estimating expected returns, making it suitable for more complex investment scenarios. One of the fundamental tasks in financial analysis is to estimate the expected return and risk of different assets, portfolios, and projects. This allows investors, managers, and analysts to make informed decisions about how to allocate their resources, diversify their risks, and evaluate their performance.

• In this post we’ll pit the two models against each other so you can identify which is more useful to you when you have an investment decision to make.
• On the other hand, it is not always possible to know the right factors or to find the right data, which is when CAPM may be preferred.
• This similarity between the two models is unsurprising as APT was developed as an extension of CAPM.
• Even as CAPM and APT help assess market risks, they both remain static and rely on too few factors to forecast risk in an extremely complicated market.
• While both APT and CAPM offer valuable insights, they also have their limitations.

The analyst behind the calculation can use whatever factors they feel apply to every case. Still, both models are unrealistic in assuming that assets are unlimited in demand and availability, that you can get these assets for free, and that investors arrive at the same conclusions. Given that CAPM is relatively easy to calculate, I suggest computing this initially, and then evaluating whether it is worthwhile to continue to evaluate the APT. Either method should give you a reasonable estimate of whether an asset merits your investment at the current time. Based on the discussion above, we can say that the APT will always be more accurate than CAPM, if the additional factors have any explanatory power.

Assumptions

The theory suggests that the expected return of any asset is based on its relation to the market portfolio. We will explain how each model defines and calculates the expected return and risk of an asset, and what are the main components and variables involved in each model. We will also show how to use these models to estimate the required return and risk premium of an asset, given its characteristics and market conditions.

It is particularly useful when analyzing assets in specific industries or regions where unique factors may influence returns. A mathematical theory for explaining security values that holds that the return on an investment is a function of the investment’s sensitivity to various common risk factors such as inflation and unemployment. Capital asset pricing model (CAPM) is widely used by investors to estimate the return or the moving behavior of the stock and Markowitz model is employed to achieve portfolio diversification. Furthermore, it is suggested to apply Markowitz portfolio diversification to reduce the unsystematic risk. The only factor you need to consider is the market risk premium, which is reasonably easy to calculate.

We will compare and contrast the main features and implications of each model, and how they relate to each other. We will also highlight some of the advantages and disadvantages of each model, and when and why one model might be preferred over the other. Another drawback is that CAPM calculations are made for just one period, with the formula being too linear. The biggest issue, though, is that calculations are not even consistent with empirical or actual results.

Stock Dividends

If the actual return of the stock is higher than 11.6%, then the investor has earned a positive alpha, and vice versa. Theoretically speaking, CAPM or APT analysis may lead to lower risk as investors use set mathematical formulae. When analysts come up with risk projections, their subjective decisions can make the picture even more complex. And while they may be rational and objective when studying risk levels, their opinions will reduce the quality of their mathematical projections. Both are based on cost against the rate of return and have their own uses and downsides. The theorems are a bit complicated to understand at first, but taking your time with them will help you get an idea of how they are applied in real life.

The APT does not offer information as to what these factors might be, though, which means APT users should examine all factors that could possibly impact the asset’s returns. On the other hand, the CAPM relies on the difference between the expected and the risk-free rate of return. The main difference is that while CAPM is a single-factor model, the APT is a multi-factor model.

The CAPM only takes into account one factor—market risk—while the APT formula has multiple factors. And it takes a considerable amount of research to determine how sensitive a security is to various macroeconomic risks. Where $E(R_i)$ is the expected return of asset $i$, $R_f$ is the risk-free rate, $\beta_i$ is the beta of asset $i$, and $E(R_m)$ is the expected return of the market portfolio. The main problem with APT, however, is that it tries to accurately measure the risk for all assets. While you can determine a “factor portfolio” (reflecting very similar risks), the risk level is still essentially influenced by macroeconomic factors. The reason for this was that CAPM has long struggled to prove itself accurate in empirical tests.

In the CAPM, the only factor considered to explain the changes in the security prices and returns is the market risk. The CAPM assumes that there is a linear relationship between the assets, whereas the APT assumes that there is a linear relationship between risk factors. This means that where there no linear relationship exists, the models are unable to adequately predict outcomes. Whilst CAPM and APT formulas appear similar, the CAPM has only one factor and one beta.

By contrast APT requires you to determine which variables are relevant to a particular asset, and then calculate the sensitivities for all of them. However, if you can manage this successfully, then APT is likely to give a more accurate and reliable result. Portfolio theory is concerned with total risk as measured standard deviation. APT in comparison to CAPM uses fewer assumptions and can be harder to use as well. The theory was developed with the assumption that the prices of securities are affected by many factors, which can be sorted into macroeconomic or company-specific factors.