CAPM vs. APT
Asset Pricing Model are very useful tools that enable financial annalists or just simply independent investors evaluate the risk in an specific investment and at the same time set a specific rate of return with respect the amount of risk of an individual investment or a portfolio. The CAPM method while simpler than the ATP method takes into consideration the factor of time and does not get too wrapped up over the Systematic risk factors that sometimes we can not control. In this paper, I will explain some of the advantages and disadvantages of the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). These are tow methods that while different from each other, they try to explain and provide the same type of information in a unique way. As people become more exposed to a highly volatile stock market and try to invest their money in any other type of investment these pricing methods become key elements when evaluating an investment and will greatly put in perspective the return to risk ratio in order to make good financial decision. Now, I would like to start by talking about the two pricing methods and highlight some of their advantages and disadvantages. The Arbitrage Pricing Theory (APT) is a very detailed pricing method. The APT is based on five different economical factors. The factors are: business cycle, time horizon, confidence, inflation and market timing risk. “The primary advantage of using the APT in portfolio selection and portfolio risk

management is that the model makes the fundamental sources of risk explicit.”1 In this method these factors are related to the expected return of risky investments. By using these macroeconomic variables it provides a way to estimate the risk premium for every individual variable. Why is that important to an investor? For some investors some risk criteria or variable is more important than others. For example, for an investment that is mostly exposed to a...

...A Chartered Financial Analyst, Jeffrey Bruner, uses the CapitalAssetPricingModel (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage PricingTheory (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 CapitalAssetPricingModel (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...

...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 Arbitrage PricingTheory (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...

...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...

...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...

...Chapter 9: Multifactor Models of Risk and Return. (QUESTIONS)
1. Both the capitalassetpricingmodel and the arbitrage pricingtheory rely on the proposition that a no-risk, no-wealth investment should earn, on average, no return. Explain why this should be the case, being sure to describe briefly the similarities and differences between CAPM and APT. Also, using either of these theories, explain how superior investment performance can be establish.
Answer:
Both the CapitalAssetPricingModel and the Arbitrage PricingModel rest on the assumption that investors are reward with non-zero return for undertaking two activities:
(1) committing capital (non-zero investment); and (2) taking risk. If an investor could earn a positive return for no investment and no risk, then it should be possible for all investors to do the same. This would eliminate the source of the “something for nothing” return.
In either model, superior performance relative to a benchmark would be found by positive excess returns as measured by a statistically significant positive constant term, or alpha. This would be the return not explained by the variables in the model.
2. You are the lead manager of a large mutual fund. You...

...Assignment:
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
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...

...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...

...CHAPTER 9
THE CAPITALASSETPRICINGMODEL
9.1 THE CAPITALASSETPRICINGMODEL
1. The CAPM and its Assumptions
The capitalassetpricingmodel (CAPM) is a set of predictions concerning equilibrium expected re¬turns on risky assets. Harry Markowitz laid down the foundation of modern portfolio man¬agement in 1952. The CAPM was developed 12 years later in articles by William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966). The time for this gestation indicates that the leap from Markowitz's portfolio selection model to the CAPM is not trivial.
We summarize the simplifying assumptions that lead to the basic version of the CAPM in the following list. The trust of these assumptions is that we try to assure that individuals are as alike as possible, with the notable exceptions of initial wealth and risk aversion. We will see that conformity of investor behaviour vastly simplifies our analysis.
1. There are many investors, each with an endowment (wealth) that is small compared to the total endowment of all investors. Investors are price-takers, in that they act as though security prices are unaffected by their own trades. This is the usual perfect competition assumption of microeconomics.
2....

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