Arbitrage Pricing Theory – Part Three

 

Having previously discussed them, let’s compare them. How does the Arbitrage Pricing Theory (APT) stack up against the Capital Asset Pricing Model (CAPM)?

Both theories are important mechanisms for pricing assets.  The APT assumes less than CAPM. Whereas CAPM relies on probabilities and statistics, APT provides for cause and effect to explain its predictions of asset returns.  CAPM assumes investors hold a mix of cash and the market portfolio, whereas APT allows each investor to hold his own portfolio with its own unique beta. So if you applied APT to the market portfolio, the example would degenerate into CAPM, because the securities market line would be a single factor price model in which beta is exposure to price changes in the market portfolio.

Since the beta in CAPM is correlated to asset demand based on each investors incremental utility for each asset, it is considered a demand-side model. In contrast, APT is a supply-side model, because its betas correlate an asset’s return to specific economic factors.  Any sudden change to one of these factors would ripple through the market containing the asset, and thus are inputs to asset returns.

Both models assume perfect competition within markets:

  • Buyers are price-takers, and are too small to affect prices.
  • Assets are infinitely liquid, and  supply and demand will reach equilibrium at a certain price.
  • There are no barriers to entering or leaving a market.
  • There are no trading costs such as commissions, taxes or fees.
  • All investors share a sole motivation: to maximize returns.
  • A given share of a security is the same as any other share, regardless of where (i.e. on which exchange) the security is exchanged.

The only factor in CAPM is the market portfolio. ABT is a multi-factor model and has one additional requirement: the number of factors must be no greater than the number of assets.  Certain assumptions are made about APT factors:

  • The factors are macroeconomic in nature, and thus create risks that cannot be easily avoided through diversification.
  • Factors affect asset prices through shocks (unexpected changes).
  • All information about each factor is well-known and accurate.
  • There is some real-world relationship between a factor and an asset.

So, which model better predicts asset returns? The answer is not clear. Quoting from a study published in the Asia-Pacific Business Review, March, 2008 by Rohini Singh: “The macroeconomic factors used in this study were able to explain returns marginally better [using APT] than [CAPM] beta alone. While this confirms that risk is multidimensional and that we should not depend on beta alone, further research is required to identify other variables that can help explain the cross section of returns.

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Copyright 2011 Eric Bank, Freelance Writer

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