The capital asset pricing model (CAPM) introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin in 1972is an important method to predict the risk and return in assets. Nowadays, the CAPM is still widely used in applications as it is a so simple and attractive tool. However it has the problems in many circumstances and we need some other extended and available models to evaluate the risk and return of assets.
We know that CAPM is a model used to price an individual security or portfolio under many strict assumptions. It is no doubt that it gives a simple model as there are a lot of assumptions.Although it is a main tool used to analyse the security market, the problems of it are very significant. In order to analyse these problems, we compare the CAPM model with the APT model firstly.
Unlike the CAPM, the number of assumptions in APT is fewer than that of CAPM. But it has more estimators than the CAPM which can be seen from the formula below:
R=RF+ (R1-RF)×β1+(R2-RF)× β2 +(R3-RF)×β3+…(RK-RF)×βk
In this equation, the β1, represents for the beta to the first factor, β2 represents the beta to the second factor and so on. The factors can be GNP, inflation, interest rate of the systematic risk. Quite different from the CAPM, we can see from the equation that the APT has many betas respect to factors of systematic risk. However, we have to estimate only one beta in CAPM. And it can be shown clearly by the following equation:
The β in CAPM is a parameter which plays an important role in modern finance as a means to estimate the risk of assets. Given the definition of beta in the book of Modern Financial Management,we know that the beta here means the responsiveness of the security’s return to movement in the market. But it also indicates that we have just one factor to concern. Comparing the beta in CAPM and the betas in APT, we can see the significant problem in CAPM of the practical use. The β in CAPM can only tell the amount of risk but can’t tell where these risks come from. But the betas in APT are composed by a lot of factors as GNP, inflation, interest rate and so on. That means the APT can tell not only how much the risk affects but also where these risk come from. Then it can give a better way for investors to consider the decisions. Also, as APT formulation has more factors to concern, it has the potential to measure expected returns more accurately than CAPM. And there is the evidence in the essay “Economic Forces and the Stock Market” by Richard Roll and Stephen Ross in 1984. It successfully explains the reasons of floating expected returns and prices of stocks using the spread between long and short interest rates, expected and unexpected inflation, industrial production, and the spread between high- and low-grade bonds under the APT. It gives the strong empirical test of APT to support the practical use of the APT instead of the CAPM.
We know that CAPM assumes that all investors...