The Capital Asset Pricing Model asserts that expected returns are linearly relat

Question

The Capital Asset Pricing Model asserts that expected returns are linearly related to a single systematic source of risk, i.e. the risk of the market portfolio. In this model, beta is a relative measure of market portfolio risk. An alternative model, the APT model, claims that expected returns are linearly related to a variety of systemic factors, k of them, and that means that there are numerous betas. Specifically, E[R] = rf + ß1f1 + ß2f2 + ß3f3 + ß4f4 … +ßkfk where ßk is the risk exposure of the kth factor and fk is the factor risk premium for the kth factor. If k were equal to one, the APT model would be the same as the CAPM. The APT model gives investors a bit more opportunity when constructing a portfolio. If investors can identify the factors that drive investment returns, they will have much better estimates of the true expected asset returns and the covariance matrix, allowing for superior returns. Question: To what extent does the CAPM model coincide with, or collide with, a stock-picking investment strategy (such as Warren Buffet’s). To what extent does the APT model coincide with, or collide with, a stock-picking investment strategy?

Explanation / Answer

CAPM Model

CAPM model presents a very simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory. The big sticking point is beta.

The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong.

Extents to which it coincides wth a stock- picking investment strategy:

Although it is difficult to predict from beta how individual stocks might react to particular movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than the market in either direction, and a portfolio of low-beta stocks will move less than the market.
This is important for investors - especially fund managers - because they may be unwilling to or prevented from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead. Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold securities with betas in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is falling.

The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It provides a usable measure of risk that helps investors determine what return they deserve for putting their money at risk

APT Model

The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors. Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. A mispriced security will have a price that differs from the theoretical price predicted by the model. By going short an over priced security, while concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in a position to make a theoretically risk-free profit.

APT model coincides with the stock-picking strategy to a larger extent than CAPM model

The general idea behind APT is that two things can explain the expected return on a financial asset: 1) macroeconomic/security-specific influences and 2) the asset's sensitivity to those influences. This relationship takes the form of the linear regression formula above.

There are an infinite number of security-specific influences for any given security including inflation, production measures, investor confidence, exchange rates, market indices or changes in interest rates. It is up to the analyst to decide which influences are relevant to the asset being analyzed.

Once the analyst derives the asset's expected rate of return from the APT model, he or she can determine what the "correct" price of the asset should be by plugging the rate into a discounted cash flow model.

Note that APT can be applied to portfolios as well as individual securities. After all, a portfolio can have exposures and sensitivities to certain kinds of risk factors as well.

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