Capital Asset Pricing Model and Arbitrage Pricing Theory

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A Chartered Financial Analyst, Jeffrey Bruner, uses the Capital Asset Pricing Model (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (APT) instead. As the following, it will mention the role of CAPM in the modern portfolio management; to clarify the APT faction and explain the reasons why should Bruner use APT to help identify mispriced securities. In modern portfolio management, the role of Capital Asset Pricing Model (CAPM) is a model that attempts to describe the relationship between the risk and the expected return on an investment and that is used in the pricing of risky securities. The assumption behind the CAPM is that there is only one risk-free rate in the model, investors can borrow and lend unlimited amounts under the risk rate of interest; the perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and the capital market is characterised by perfect competition, there are broadly diversified across a range of investments and the investors will only require a return for the systematic risk of their portfolio, since unsystematic risk has been removed and can ignored. It also assumes all investors choose their portfolio according to the mean-variance criterion which ignores practical considerations such as trade without transaction or taxation costs. Under these assumptions, the market portfolio lies on the efficient frontier. The CAPM is represented as: E(Ri) = Rf + βi [E(RM)- Rf] The CAPM is remarkable because it tell us what should be the expected or required rates of return on all risky assets. The Security Market Line (SML) represents this relationship. Where E(Ri) is the appropriate expected rate of return on securities or portfolio I, Rf is the risk-free rate, E(RM) is the expected return on the market, and βi (beta) is the sensitivity of the...
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