Compare and contrast CAPM and APT?
Capital asset pricing model (CAPM) and arbitrage pricing theory (APT) are both methods of assessing an investment's risk in relation to its potential reward and whether the potential investment yield is worthwhile.

CAPM developed by Sharpe 1964. The basic theory behind this model is that investor needs to be compensated for Time Value of Money and the risk that they are taking.

The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk. This is calculated by taking a risk measure of the market (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

APT developed by Ross 1978. The basic theory of arbitrage pricing theory is the idea that the price of a security is driven by a number of factors such as macro factors, and company specific factors.

Formula:
r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅

Where r is the expected return on the security,
rf is the risk free rate,
Each f is a separate factor and
each β is a measure of the relationship between the security price and that factor.

The CAPM bases the price of stock on the time value of money (risk-free rate of interest (rf)) and the stock's risk, or beta (b) and (rm) which is the overall stock market risk. APT does not regard market performance when it is calculated. Instead, it relates the expected return to fundamental factors. APT is more complicated to calculate compared to CAPM because more factors are involved. CAPM uses the formula: expected rate of return (r) = rf +b (rm - rf). The formula for APT is: expected return = rf + b1 (factor 1) + b2 (factor 2) + b3 (factor 3). APT uses a beta (b) for each particular factor regarding the sensitivity of the stock price.

...CAPITALASSETPRICINGMODEL
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk [pic]premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
THE CAPM MODEL
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
[pic]
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the [pic]formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of...

...CapitalAssetPricingModel
The CapitalAssetPricingModel otherwise know as CAPM defines the relationship between risk and return for individual securities. William Sharpe published the capitalassetpricingmodel in 1964. CAPM extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller
CAPM assumes the concept of a logical investor, assumes a perfect market, and uses a measure of investment risk known as a Beta. When CAPM assumes these three concepts above there has to be a definition to describe the assumptions.
Therefore when we assume a logical investor we are actually referring to an investor that makes his or her investments based upon the expectation of a return. Investors will anticipate their return by analyzing the stock market's average rate of return and that will be their expectation when looking into a specific security. If they are not going to anticipate their return to equal the markets average rate of return then there will be no reason to invest. You invest to make a profit. Investors invest to make a profit. Furthermore a logical investor accepts the market rate of risk. Since they are anticipating the average...

...1. For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
Undiversifiable (market )risk:
Market risk is the variability in all risky assets caused by macroeconomic variables. This risk cannot be avoided, regardless of the amount of diversification. Systematic risk (Market risk) factors are those macroeconomic variables that affect the valuation of all risky assets such as variability in the growth of the money supply, interest rate volatility, variability in aggregate industrial production, and natural shocks like drought, earth quake, hurricane, etc.
Diversifiable (unique )risk:
Many of the risks faced by an individual company are peculiar to its activity, its management, etc. These are the unique risks and can be diversified away. Examples of unique risks are a company winning a large contract, wildcat strikes hitting a company, litigation hitting a company or the company facing a governmental investigation.
a. A large fire severely damages three major U.S. cities.
Diversifiable risk
The entire economy will not be affected by a large fire in three major US cities. In fact some companies in cities not affected by fire will benefit as they will meet the demand not being met by companies in the three cities that are...

...CapitalAssetPricingModel: The Indian Context
R Vaidyanathan
T
he CapitalAssetPricingmodel is based on two parameter portfolio analysis
model developed by Markowitz (1952). This model was simultaneously and
independently developed by John Lintner (1965), Jan Mossin (1966) and
William Sharpe (1964). In equation form the model can be expressed as follows:
E (Ri) = Rf + (i [E(rm) – Rf] = Rf +(im / (m (E(Rm) – Rf / (m)
Where E(Ri) is expected return on asset i, Rf is the risk-free rate of return, E(Rm) is expected return on market proxy and (i; is a measure of risk specific to asset i. This relationship between expected return on asset i and expected return on market portfolio is also called the security market line. If CAPM is valid, all securities will lie in a straight line called the security market line in the E(R), (i frontier. The security market line implies that return is a linearly increasing function of risk. Moreover, only the market risk affects the return and the investor receive no extra return for bearing diversifiable (residual) risk.
The set of assumptions employed in the development of the CAPM can be summarized as follows [Sears and Trennepohl (1993)]:
1. Investors are risk-averse and...

...Running head: PRICINGMODELSPricingModels
Adam F. Thornton
FIN 501 – 3
TUI University
Dr. William Anderson
Chipotle Mexican Grill (CMG) is one of the fastest growing restaurant chains in the United States. Self proclaimed as “fast-casual,” CMG offers a dining experience that is unique, organic, and which draws from the local economy. For the investor, CMG is a wise investment for the aggressive and fast growing portion of a portfolio. When determining an appropriate model to evaluate CMG’s potential, the CapitalAssetPricingModel (CAPM) is the best choice. This model offers the best amount detail while maintaining the simplicity needed for a model outlining investment decisions in CMG.
The PricingModels
There are three pricingmodels to discuss when evaluating CMG: dividend growth, CAPM, and the ArbitragePricingTheory (APT). Each of these models has both advantages and disadvantages, easily tailoring one model to different situations. However, the CAPM is best suited for this case with CMG. Below is a further review on each of models’ advantages and disadvantages, and applicability to CMG’s market position and financial...

... explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There's a substantial unexpected increase in inflation.
b. There's a major recession in the U.S.
c. A major lawsuit is filed against one large publicly traded corporation.
2. Use the CAPM to answer the following questions:
a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.
b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.
c. What do you think the Beta (β) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.
3. In one page explain what you think is the main 'message' of the CapitalAssetPricingModel to corporations and what is the main message of the CAPM to investors?
1. For each of the scenarios below, explain whether or not it represents a diversifiable or an un-diversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning
a. There’s a substantial unexpected increase in inflation.
Un-diversifiable risk
The entire...

...CapitalAssetPricingModel (CAPM): Pros and Cons.
CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect.
Shows:
• how much risk you are taking when investing in an instrument?
• whether the instrument is rightly priced
• whether you are getting sufficient return for the risk you are taking
CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):
Return (R) = Rf + beta x (Rm - Rf)
Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company
Investments are good if the expected return from the investment equals/exceeds required return.
Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk
Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion
Varies across time. Usually ranged between 4-8%
BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a...

...
How far the CapitalAssetPricingModel has been successful in explaining asset returns, defining its approach and assumptions.
Semester 2013
Department of Accounting and Finance
Lord Ashcroft International Business School
Anglia Ruskin University
Table of Contents
Introduction…………………………………………………………………………......... 3
What’s CapitalAssetPricingModel…………………………………………………..... 3 1. Definition………………………………………………………………………………...3 2. Terminology……………………………………………………………………………...3
Risk and CapitalAssetPricingModel………………………………………………….. 3 1. Systematic Risk…………………………………………………………………………..3 2. Unsystematic Risk………………………………………………………………………..3
Asset Returns and CapitalAssetPricingModel……………………………………….. 3
CapitalAssetPricingModel...

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