Difference Between Capm And Arbitrage Pricing Model
2.1 Theoretical literature review
The Capital Asset Pricing Model (CAPM) was formulated by Sharpe (1964) as well as Lintner (1965) following the work of Markowitz (1959). Since then it has produced amazing achievement because its simplified approach attracted many researchers. In spite of numerous criticisms concerning the validity of the CAPM, it is broadly used in the field of financial economics. Alternatively we have the Arbitrage Pricing Theory (APT), being a less limiting model as opposed to the CAPM, however, …show more content…
Rf = Risk-free rate. βi = Beta of the security i.
E(Rm) = Expected return of the market.
E(Rm) – Rf = Market premium.
From the above equation, it is shown that the CAPM is an equilibrium model that specifies the relationship between the risk and the expected return for assets that is held in a well-diversified portfolio. Sharpe (1964) stated that the single determinant of return is beta.
Beta computes the systematic risk and betas can be aggressive, defensive or neutral. Aggressive stocks have a beta greater than 1. Their returns proceed with a higher percentage compared to the market in general and they are worth keeping in growing markets. Defensive stocks possess a beta under 1 and their returns tend to undervalue those of the entire market. Defensive stocks provide safety against faltering market. Neutral stocks possess betas of nearly 1 and their returns are parallel to the returns of the market portfolio. Usually, the larger the beta, the larger is the risk premium and the total return required.
Figure 1: Securities Market …show more content…
They used monthly return for the period 1969 to 1983 from securities listed on Tokyo Stock Exchange, American Stock Exchange, Paris Bourse and London Stock Exchange. All assets traded on the different exchanges were included. Asymptotic principle components were used to estimate the factors used for APT. The results depicts that a strong relationship of the indexes and the estimated factors for every country was observed except those of France. Each five factors successfully explain returns and are statistically significant. The domestic versions of both models slightly do better than the international version, except for the CAPM value-weighted form. It also appeared that in January, APT has better explanatory power than the