Difference Between CAPM and APT Essay Sample

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  • Word count: 490
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CAPM vs APT For shareholders, investors and for financial experts, it is prudent to know the expected returns of a stock before investing. There are various statistical models that compare different stocks on the basis of their annualized yield to enable investors to choose stocks in a more careful manner. CAPM and APT are two such valuation tools. Before we try to find out the differences between APT and CAPM, let

and CAPM, let us take a closer look at the two theories. APT stands for Arbitrage Pricing Theory that has become very popular among investors because of its ability to make a fair assessment of pricing of different stocks. The basic assumption of APT is that the value of a stock is driven by a number of factors. First there are macro factors that are applicable to all companies and then there are company specific factors. The equation that is used to find the expected rate of return of a stock is as follows. r= rf+ b1f1 + b2f2 + b3f3 + …..

Here r is the expected return on security, f is different factors affecting the price of the security, and b is the measure of relationship between the price of security and the factor. Interestingly, this is the same formula that is used to calculate the rate of return with CAPM, which stands for Capital Asset Pricing Model. However, the difference lies in the use of a single non company factor and a single measure of relationship between price of asset and the factor in the case of CAPM whereas there are many factors and also different measures of relationships between price of asset and different factors in APT. Another difference is that in APT, the performance of the asset is taken to be independent from the market and its price is assumed to be driven by non company and company specific factors. However, one drawback of APT is that there is no attempt to find out these factors, and in fact one has to himself find out empirically different factors in case of every company that he is interested in finding the pricing of. More the number of factors identified, the more complicated the task becomes as one has to find different measures of relationships of price with different factors also. These are the reasons why CAPM is being preferred over it by investors as well as financial experts. In brief:

• Similarities between APT and CAPM are that both make use of the same equation to find the rate of return of a security • However, whereas there are many assumptions made in APT, there are comparatively lesser assumptions in case of CAPM. • In APT, there are company specific risk factors and different betas for each factor have to be calculated individually empirically whereas there is no such requirement in case of CAPM.

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