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The Capm and Apt; Does One Outperform the Other?

  • Date Submitted: 01/28/2010 04:14 AM
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Before making comparison between the CAPM and APT, we should first see what they are about.

The CAPM is a theory about the way how assets are priced in relation to their risk. The CAPM was brought about to answer the question which came from Markowitz’s

mean-variance portfolio model. The question was how to identify tangency portfolio. Since then, the CAPM has developed into much, much more. CAPM shows that equilibrium rates of return on all risky assets are a function of their covariance with market portfolio. APT is another equilibrium pricing model. The return on any risky asset is seen to be a linear combination of various common factors that affect asset returns. These two models in fact are similar to each other in some way.

CAPM Assumptions:

• Investors are risk averse individuals and they maximise their expected utility of their end of period wealth. They have the same one period of time horizon.

• Investors are price takers (no single investor can affect the price of a stock) and have homogenous expectation about asset returns that have a joint normal distribution.              

• Investors can borrow or lend money at the risk-free rate of return.

• The quantities of assets are fixed. All assets are marketable and perfectly divisible.

• Asset markets are frictionless and information is costless and simultaneously available to all investors.

• There are no market imperfections such as taxes, no transaction costs or no restrictions on short selling.

As we can see, many of these assumptions behind the CAPM are not realistic. Although these assumptions do not hold in the real world, they are used to make the model simpler for us to use for financial decision making. Most of these assumptions can be relaxed.

The CAPM requires that in equilibrium the market portfolio must be an efficient portfolio. As long as all assets are marketable, divisible and investors have...


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