Question

‘Many practitioners consider the Arbitrage Pricing Theory (APT) a superior approach to the pricing of risky assets than the Capital Asset Pricing Model (CAPM)’.

Discuss the above statement paying particular attention to the differences in the assumptions underlying the two methods.

Answer 1

The APT is a more flexible and complex alternative to the Capital Asset Pricing Model (CAPM). The theory provides investors and analysts with the opportunity to customize their research.

The Arbitrage Pricing Theory operates with a pricing model that factors in many sources of risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM) which only takes into account the single factor of the risk level of the overall market, the APT model looks at several macroeconomic factors that, according to the theory, determine the risk and return of the specific asset.

These factors provide risk premiums for investors to consider because the factors carry a systematic risk that cannot be eliminated by diversifying. The APT suggests that investors will diversify their portfolios, but that they will also choose their own individual profile of risk and returns based on the premiums and sensitivity of the macroeconomic risk factors. Risk-taking investors will exploit the differences in expected and real returns on the asset by using arbitrage.