CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
Consider the limitations of the Capital Asset
Pricing Model and the extent to which the
Arbitrage Pricing Model has overcome these
limitations.
Mohammed H. Khan
(08178887)
University of Hertfordshire
Mini Report 2
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
Table Of Contents Page No.
Introduction ..............................................................................1
Capital Asset Pricing Model ......................... 1
Arbitrage Pricing Model ..................................... 5
APM contends with the CAPM ................................. 7
Conclusion.............................................................. 9
Reference .............................................................................. 8
Bibliography .......................................................................... 10
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
Introduction
“Perfection is immutable. But for things imperfect, change is the way to perfect them”
- Owen Felltham
The quote above seamlessly sums up the essence of the report. The Capital asset pricing
model (CAPM) was developed to provide investors with an idea of the expected returns their
investments would obtain. However, the assumptions made by the CAPM meant the CAPM
operated in an idealised world. To better the model the Arbitrage pricing model (APM) was
born. It relied on fewer assumptions and believed a securities returns where not entirely
dictated by a single variable the return on the market as purported by the CAPM but
suggested returns were reliant on a number of macroeconomic factors. The APM does not
suggest what these macroeconomic factors are.
Both risk models rely on historical data to come up with future expected returns. Historical
data should only be used if security prices are stable which in practise they are not. Perhaps,
the APM is an improvement on the CAPM but is still far from being perfect. So change is
still required to produce a perfect model which can derive a perfect expected return.
Capital Asset Pricing Model
The Capital asset pricing model (CAPM) is a method of share valuation which uses
systematic risk, of individual securities to determine their fair prices. Systematic risk is the
market risk which represents the relative effect on the returns of an individual security of
changes in the market as a whole. (Investopedia: 2010)
In order to ignore the influences of unsystematic risk/firm specific risk on the valuation of
shares it is assumed investors have eradicated unsystematic risk by holding diversified
portfolios. Central to the CAPM is the existence of a linear relationship between risk and
return. The linear relationship is defined by what is known as the security market line (SML)
as shown in the graph. The systematic risk of the
security is compared with the risk and return of the
market in order to calculate a required return for the
security and a fair price. The formula of the CAPM:
E(Ri) = Rf + β (Rm - Rf)
Where, E(Rt) = expected return of individual security,
Rf = risk free rate security, Rm = market return , β = beta
which is defined as an index of responsiveness of the Source: Watson & Head: 2007
changes in returns of the security to a change in the stock exchange or market (Watson &
Head: 2007).
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
The CAPM is a single period model. In order to apply CAPM, it is necessary to specify the
holding period. The holding period in turn determines the risk-free rate, since that rate must
prevail over the holding period. The appropriate risk-free rate is thus the interest rate on a
risk-free security with a maturity that matches the holding period
The CAPM suggests the investors need to be compensated in two ways. That is time value of
money and risk. The time value of money is represented by the Rf and compensates the
investor for placing money in an investment over a period of time. The other half of the
formula, the risk premium represents the risk taken on by the investor and calculates the
amount of compensation the investor needs for taking on additional risk. Supporters of the
CAPM argue that β, a measure of systematic risk relative to the market portfolio is the sole
determinant of return. Any additional variability caused by events peculiar to the individual
asset can be “diversified away”. Capital markets do not reward risks borne unnecessarily.
(Bhole: 2009)
The CAPM is often criticised for being unrealistic because of the assumptions on which it is
based. The assumptions are:
- Investors hold diversified portfolios – this assumption suggests investors will only
require a return for the systematic risk of their portfolios as unsystematic risk has
been removed.
- All investors aim to maximize utility
- Investors are rational and risk averse
- All investors are price takers i.e. they cannot influence prices.
- Single period transaction horizon - To make investment returns comparable on
different securities the investments should be held for the same period. For example
a return on investment A which is held for 6 months cannot be compared to the
returns of an investment held for 1 year.
- Investors can borrow and lend at the risk free rate – this assumptions suggests the
minimum level of return required by investors.
- Perfect capital markets - This assumptions means all securities will be valued
correctly and their returns will plot on the SML. A perfect market assumes all
investors have similar expectations about asset prices and other factors, there are a
large number of buyers and sellers, information has no cost and is freely available
and there are no taxes nor any transaction costs e.g. brokerage costs.
While the assumptions made by the CAPM allow it to focus on the relationship between
return and systematic risk, the idealised world created by the assumptions is not the same as
the real world in which investment decisions are made by companies and individuals. For
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
example, real world capital markets are not perfect but can be classed as merely efficient,
which means there is scope for securities in the stock market to be priced incorrectly and not
plot on the security market line (SML).
The assumption of a single period transaction horizon appears reasonable from a real world
perspective as many investors hold securities for much longer than 1 year.
The assumption that investors hold diversified portfolios suggests that all investors want to
hold a portfolio that reflects the stock market as a whole; this is a reasonable assumption as it
is easy and inexpensive for investors to diversify away unsystematic risk and construct
portfolios that track the stock market.
Overall the assumptions seem reasonable to conclude that while the assumptions of the
CAPM represent an idealised rather than a real view there is a strong possibility in reality of a
linear risk return relationship existing between required return and systematic risk.
Arbitrage Pricing Model (APM)
The APM has the potential to overcome CAPM weaknesses. It requires less and more
realistic assumptions to be generated by a simple arbitrage argument and its explanatory
power is potentially better since it is a multifactor model. However, the power and the
generality of the APM are its main strength and weakness: the APM permits the researchers
to choose whatever factors provide the best explanation for the data but it cannot explain
variation in asset return in terms of a limited number of easily identifiable factors. In contrast,
CAPM theory is intuitive and easy to apply. (Cagnetti: 2003)
The APM assumes stock returns depend on macroeconomic influences or factors and partly
by noise, events which are specific to the company. (Brealey & Myers: 2000)
The formula of the APM is:
ERI = Rf + B1 (ER factor 1 – Rf ) + B2 ( ER factor 2 – Rf) ... + noise
ERI = expected return on investment
Rf = risk free rate
B1 = sensitivity of the return on security to factor 1
Noise = the random deviation based on unique events impacting on the security’s returns.
So instead of having one beta to measure the systematic risk of the investment, the APM has
many. Each beta measures the sensitivity of a company’s stock returns to macroeconomic
factors. The APT does not state what the factors are, according to Gattes (1995) these factors
include:
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
- Real GNP growth
- Industrial production index
- Exchange rate
- Commodity Prices
- Inflation
- Interest rates
Similar to that of the notion held by CAPM that unsystematic risk in a portfolio is eliminated
by diversification, The APM also holds this and assumes that systematic risk from
macroeconomic factors cannot be eradicated.
Some stocks will be more sensitive to a particular factor than other stocks. For example,
Exxon Mobil would be more sensitive to oil factors than say Coca Cola.
The APM suggests that the expected risk premium on a stock should depend on the expected
risk premium associated with each factor and the stocks sensitivity to each of the factors.
(b1,b2,b3.......) the expected risk premium is the additional return for making a risky
investment
The APM claims a stock in a portfolio should offer an expected return based on its
contribution to portfolio risk. The contribution depends on the sensitivity of the stocks return
to unexpected changes in macroeconomic factors.
Arbitragers use the APM to profit by taking advantage of mispriced securities. A mispriced
security is defined as a price that differs from the theoretical price predicted by the model.
Successful use of the APM is dependent on choosing key factors and the ability to measure
the sensitivity of the companies share value to the factor.
APM contends with the CAPM
Eugene Fama and Kenneth French (F&F) (1992)
rebut the risk return relationship put forward by
the CAPM. In their research there was no
apparent risk and return relationship, as shown in
the graph suggesting beta appears to be of no
use to the investor.
A prominent critic of the CAPM Roll (1977)
suggested it was impossible to test the CAPM, as
the market portfolio could not be observed as it is impossible to create a truly diversified
market portfolio, as a true "market portfolio" includes every investment in every market,
including commodities, collectibles and virtually anything with marketable value. Those who
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
still use the CAPM do so with a market index, such as the S&P 500, as a proxy for the overall
market.
The CAPM is considered a specialized case of the APT, where there is only one underlying
factor and it is completely measured by the market index. Although this makes the CAPM a
simpler model it also contributes to its downfall for there are investments which are sensitive
to economic factors that are not well represented by the market index. For example, oil
company stocks derive most of their value from oil price and usually have low betas and low
expected returns. With the APM in application where one factor is used to measure oil and
other price commodity movements, it will yield a better estimate of risk and higher expected
return for the firm. (Geddes: 1995).
In Cagnettis’ (2003) study of the CAPM vs APM, suggests a security’s return is significantly
influenced by a number of systematic forces and their behaviour can only be explained
“through the combined explanatory power of several macroeconomic variables”. His study
showed there was no correlation between beta and return in the Italian stock market between
1990 and 2001 and that the CAPM displayed poor explanatory power. On the other he
discovered the APM to be a more powerful method that considers risk associated with other
variables other than the market portfolio. He infers in his conclusion that although the market
return is an important element, the behaviour of securities is complex and cannot be
explained by a single factor. He believes securities are significantly influenced by a number
of systematic forces and their behaviour can only be explained by several macroeconomic
variables. However, Collins (1988) argues although the number of factors that affect the price
of individual assets is very large. Most of these factors, however, are unique to particular
firms or groups of firms, and their effects may be diversified away. Assuming these
individual effects can be eliminated by costless diversification, they will not affect the return
required by investors.
The assumption of single period transaction horizon restricts investors to a duration which
they have to specify. For example, to apply the CAPM it is necessary to specify the holding
period, which is used to determine the risk free rate which is the rate that must prevail over
the holding period. The appropriate risk free rate is the interest rate on a risk free security
with a maturity that matches the holding period. The problem with this is in practise investors
have the option to hold onto a portfolio for as long as they like. If investors are unsure as to
how long they will hold an asset the CAPM cannot be used to provide an expected rate. The
APM is not a single period model, so it does not restrict itself to a “time frame”. The APM is
therefore a more realistic model. (Armitage: 2005)
A major downside for both models is that both rely on historical data to derive betas. Beta is
a measure of a stocks future risk. Analysts have access only to historical data on share price
thus can only estimate beta/s based on historical data. Investors can use historical beta as a
measure of future risk only if it is stable over time. Empirical research shows historical beta
is not stable over time implying that historical betas are poor indicators of future risk of
securities. This poses a conundrum for investors, for they will not be able to work out a
reliable expected rate of return using any of the two risk models. (Geddes: 1995)
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
Conclusion
The dichotomy of the two models is the number of factors they incorporate. The APM the
multifactor model provides more explanatory for the returns of the security as it does not
constrain itself to one factor like the CAPM.
Roll (1977) suggested the CAPM is impossible to test so it’s true existence as a risk model is
uncertain. He suggested the Rm element of the CAPM equation does not cover all tradable
assets with a marketable value. The APM does not suffer this problem as it does not constrict
itself to one variable. .
The APM is believed to yield a better estimate of risk and expected return as investments
which are sensitive to economic factors cannot be well represented by a single market index,
but by a profusion of macroeconomic factors.
Also, the behavior of securities returns cannot be explained by a single factor. Cagnettis
(2003) stated a security’s return is significantly influenced by a number of systematic forces
and their behavior can only be explained “through the combined explanatory power of
several macroeconomic variables”. However, this may not be entirely correct as the number
of factors that affect the price of individual assets are often specific to the firm and their
effects can be diversified away. Assuming these individual effects can be eliminated by
costless diversification, they will not affect the return required by investors.
The assumption of a single time period within the CAPM restricts the investors holding
period of the asset, the APM is not a single period model but a continuous period model
making it a more realistic risk model.
However, the major downfall of APM having multiple factors and not suggesting what they
are poses a problem. With the beta and expected risk premiums of each factor having to be
calculated which is difficult as the two are very volatile, the estimation error may eliminate
the benefits that could be gained by moving from the CAPM to the ABT.
On the whole, the reliance on historical data to generate betas and risk premiums to predict
the securities future returns is problematic for both models. As historical betas for example
can only be used if stable which in practise they are not .Thereby, reducing the accuracy of
the expected rate of return generated by both models. Posing a dilemma to investors, why
rely on the two invalid (sic) models.
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
Reference
Investopedia, (2010) Define Systematic Risk, Available at:
[Link] [Date accessed: 20 Nov. 2010]
Brealey, R. A. & Myers, B., (2000). Principles of Corporate Finance. 6th edition. New York:
McGraw-Hill Higher Education
Armitage, S. (2000). The Cost of Capital, Intermediate Theory. Cambridge; Cambridge
University Press
Damodaran, A (2003) Corporate Finance Theory and Practice.2nd edition. New York: John
Wiley & Sons, Inc.
Roll, R. “A critique of the Asset Pricing theory’ Tests: Part 1 .On part and potential
Testability of the Theory. Journal of Financial Economics, 4 (1977), pp. 129-176
Collins, R.A. “The required rate of return for publicly held agricultural equity:
an arbitrage pricing theory approach”. Western Journal of Agricultural Economics, 13(2):
163-168
Cagnetti, A. (2003) Capital Asset Pricing Model and Arbitrage Pricing Theory
in the Italian Stock Market: an Empirical Study,
Fama, E. K, French. “The Cross- Section of Expected Stock Returns.” Journal of Finance, 47
(1992), pp.427-465.
Geddes, R. (1995). Valuation and Investment appraisal, Financial World Publishing, 2nd edn.
Washington: Financial World Publishing ACT
Bhole, L M. (2009). Financial Institutions and Markets, Structure, Growth and Innovations,
5th edn. New Delhi: Tata McGraw Hill Education Limited
CAPITAL ASSET PRICING MODEL | ARBITRAGE PRICING MODEL
Bibliography
Watson,D. Head,A. (2007) “Corporate Finance Principles and Practice”.4th edition. Essex:
Pearson Education Limited