May 09, 2019 the capital asset pricing model capm and the arbitrage pricing theory apt help project the expected rate of return relative to risk, but they consider different variables. Definition of arbitrage pricing theory apt investopedia. This theory, like capm provides investors with estimated required rate of return on risky securities. A strategy can use these asset pricing models in many ways, such as building out a longshort equity strategy or hedging an existing portfolio based on factor exposures. Noarbitrage pricing approach and fundamental theorem of. Published in volume 18, issue 3, pages 2546 of journal of economic perspectives, summer 2004, abstract.
The capital asset pricing model builds directly on modern portfolio theory. The capital asset pricing model in the 21st century. It was developed in the mid1960s by william sharpe us, b. The arbitrage pricing theory as an approach to capital. On stocks, this rate of return has been about 6 percent 4 percent in the last 200 years. The capitalassetpricing model and arbitrage pricing theory. Jun 18, 2019 the capital asset pricing model and the arbitrage pricing theory can both be used to estimate a theoretical rate of return on an asset. On the other hand, in the arbitrage pricing theory apt. Before we discuss the capm, it would be important to understand risk of portfolios. In the first section i will present the main theories and the relative empirical tests developed on asset pricing in the last 60 years.
Arbitrage pricing theory gur huberman and zhenyu wang federal reserve bank of new york staff reports, no. In the security market, it is of selling security at a high price and the simultaneous trurcha of the same security at a relatively lower price. This article describes the arbitrage pricing theory apt as and compares it with the capital asset pricing model capm as a tool for computing the cost of capital in utility regulatory proceedings. Arbitrage pricing theory apt is a multifactor asset pricing model based on the idea that an assets returns can be predicted using the linear. Indeed, the drawback and limitations of these models will be addressed as well. Download limit exceeded you have exceeded your daily download allowance. Because it includes more factors, consider the arbitrage pricing theory more nuanced if not more accurate, than the capital asset pricing model. Arbitrage pricing theory apt is an alternate version of capital asset pricing capm model. The big difference between apt and capm is that capm only looks at the asset in comparison to market changes, whereas apt looks at multiple factors. The stochastic discount factor sdf of an asset pricing model should always be positive if prices assigned by the model never provide arbitrage opportunities hansen and richard 1987 and harrison and kreps 1979. The objective is also to provide an overview of the state of art of apt in the context of alternative capital market theories. Essays on arbitrage pricing theory and systemic risk modeling uzh. Apr 15, 1997 on the other hand, in the arbitrage pricing theory apt.
This lecture covers the basics of the capital asset pricing. An overview of asset pricing models andreas krause university of bath school of management phone. The arbitrage pricing theory and multifactor models of asset. Better asset pricing models are some of the most researched topics in finance, with broad applications in risk management, asset allocation, and market valuations. In this case, the assetpricing model is said to be arbitragefree. Unlike the capital asset pricing model, the arbitrage pricing theory requires only the following assumptions. In this chapter we survey the theoretical underpinnings, econometric testing, and applications of the apt. The capital asset pricing model in the 21st century analytical, empirical, and behavioral perspectives the capital asset pricing model capm and the meanvariance mv rule, which are based on classic expected utility theory eut, have been heavily criticized theoretically and empirically. Apt considers risk premium basis specified set of factors in addition to the correlation of the price of the asset with expected excess return on the market portfolio. Goetzmann, yale school of management the arbitrage pricing theory approach to strategic portfolio planning pdf, richard roll and stephen. The first article, published in the january 2008 issue of student accountant introduced the capm and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula.
The stochastic process generating asset returns can be represented by a factor model. Arbitrage pricing theory and the capital asset pricing. Pdf regulation, the capital asset pricing model, and the. Capm is more reliable as the probability may go wrong. Fundamental theorem of asset pricing no arbitrage opportunities exist if and only if there exists a risk neutral probability measure q. Behavioral approach to arbitrage pricing theory munich personal. The apt is a substitute for the capital asset pricing model capm in that both assert a linear relation between assets expected returns and their covariance with. Capital asset pricing model, arbitrage pricing the ory, asset pricing. An overview of asset pricing models university of bath. This theory, like capm, provides investors with an estimated required rate of return on risky securities. Arbitrage pricing theory, often referred to as apt, was developed in the 1970s by stephen ross. Thus the equity premium was about 5 percentage points. Jan 22, 2009 roll r, ross s 1983 regulation, the capital asset pricing model and the arbitrage pricing theory. French t he capital asset pricing model capm of william sharpe 1964 and john lintner 1965 marks the birth of asset pricing theory resulting in a nobel prize for sharpe in 1990.
This thesis aims to compare the most important asset pricing theories in the. Portfolio theory and the capital asset pricing model, third the arbitrage. Capm is simple and easy to calculate while apt is c. Capm specifies that the expected return on an asset is a linear function of its beta and the market risk premium. The arbitrage pricing theory and multifactor models of. Journal of economic theory, 3460 1976 the arbitrage theory of capital asset pricing stephen a. Monetary economics this article compares two leading models of asset pricing. This article describes the arbitrage pricing theory apt as and compares it with the capitalasset pricing model capm as a tool for computing the cost of capital in utility regulatory proceedings.
The modelderived rate of return will then be used to price the asset. Capital asset pricing model and arbitrage pricing theory. Capm considers only single factor while apt considers multifactors. We show what make them successful for the pricing of assets. In finance, arbitrage pricing theory apt is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factorspecific beta coefficient. The capital asset pricing model and arbitrage pricing. Arbitrage pricing theory definition arbitrage pricing. The study compares capital asset pricing model capm with arbitrage pricing model apt as effective decision models in asset pricing with a view to identify the more appropriate and efficient one. G12 abstract focusing on capital asset returns governed by a factor structure, the arbitrage pricing theory apt is a oneperiod model, in which preclusion of arbitrage over static portfolios.
Comparison of neoclassical theories of asset pricing iorcfhsg. The capitalassetpricing model and arbitrage pricing. The arbitrage model was proposed as an alternative to the mean variance capital asset pricing model. Introduction to asset pricing 1 facts according to aiyagari 1993, the average annual real rate of return on 3month u. In finance, arbitrage pricing theory apt is a general theory of asset pricing that holds that the. Capm relies on the historical data while apt is futuristic.
Capital asset pricing model, arbitrage pricing theory and portfolio management vinod kothari the capital asset pricing model capm is great in terms of its understanding of risk decomposition of risk into securityspecific risk and market risk. The sdf of the nonlinear consumption capm is always positive. In this case, the asset pricing model is said to be arbitrage free. The arbitrage pricing theory and the capital asset pricing models and artificial neural networks modeling with particle swarm optimization pso eleftherios giovanis abstract we examine two stocks of athens exchange stock market, that of cocacola and compucon. Asset pricing models, arbitrage pricing theory and. Capital asset pricing model capm is an arithmetical theory that describes the relationship between risk and return in a balanced market. Arbitrage pricing theory apt like the capm, apt is an equilibrium model as to how security prices are determined this theory is based on the idea that in competitive markets, arbitrage will ensure that riskless assets provide the same expected return created in 1976 by stephen ross, this theory predicts a relationship between the returns of a portfolio and the. I will start from the efficient market hypothesis, proceed with the markowitz model and then i will analyze the evolutions that led to the capital asset pricing model and eventually the arbitrage pricing theory. The capital asset pricing model capm and arbitrage pricing theory apt have been commonly used techniques in the global investing community for calculating the required return of a risky asset. The capital asset pricing model capm of william sharpe 1964 and.
The separating hyperplane theorem states that if a and b are two nonempty disjoint convex sets in a vector space v, then they can. We analyze the arbitrage pricing theory apt model and the capital. Capm and apt have emerged as two famous models that have tried to scientifically measure the potential for assets to. Modern portfolio theory, the capital asset pricing model, and arbitrage pricing theory. A meanvariance efficient market portfolio consisting of all risky assets. The stochastic discount factor sdf of an assetpricing model should always be positive if prices assigned by the model never provide arbitrage opportunities hansen and richard 1987 and harrison and kreps 1979. We examine two stocks of athens exchange stock market, that of cocacola and compucon. These include the sharpelintner sl capital asset pricing models.
Roll r, ross s 1983 regulation, the capital asset pricing model and the arbitrage pricing theory. The capital asset pricing model capm and the arbitrage pricing theory apt help project the expected rate of return relative to risk, but they consider different variables. The arbitrage pricing theory apt of ross 1976, 1977, and extensions of that theory, constitute an important branch of asset pricing theory and one of the primary alternatives to the capital asset pricing model capm. I argue that while the apt is compatible with the data available for testing theories of asset pricing, the capm is not. The arbitrage theory of capital asset pricing sciencedirect. The capital asset pricing model and the arbitrage pricing theory. Capital assets pricing model capm the capital assets pricing model capm derives the expected return on an assets in a market, given the riskfree rate available to investors and the compensation for market risk.
Arbitrage is a process of earning profit by taking advantage of differential pricing for the same asset. View citations in econpapers 1293 track citations by rss feed. Arbitrage pricing theory apt is an alternate version of the capital asset pricing model capm. Comparing the arbitrage pricing theory and the capital asset. The arbitrage pricing theory differs from the capital assets pricing model in that. Capital asset pricing model, arbitrage pricing theory and. This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the capm. Capm and apt have emerged as two famous models that have tried to. Comparing the arbitrage pricing theory and the capital. Comparing the arbitrage pricing theory and the capital asset pricing model there are inherent risks in holding any asset, and the capital asset pricing model capm and the arbitrage pricing model apm are both ways of calculating the cost of an asset and the rate of return which can be expected based on the risk level inherent in the asset. Apt considers risk premium basis specified set of factors in addition to the correlation of the price of asset with expected excess return on market portfolio. The arbitrage pricing theory and the capital asset pricing.
The proof of the theorem requires the separating hyperplane theorem. When implemented correctly, it is the practice of being able to take a positive and. The formula includes a variable for each factor, and then a factor beta for each factor, representing the securitys sensitivity to movements in that factor. Capm only looks at the sensitivity of the asset as related to changes in the market, whereas apt looks at many.
The capital asset pricing model and the arbitrage pricing. Arbitrage and the empirical evaluation of assetpricing models. Treasury bills in the postwar period has been about 1 percent. It is considered to be an alternative to the capital asset pricing model as a method to explain the returns of portfolios or assets. Find all the books, read about the author, and more. The capital assets pricing model was autonomously and simultaneously developed by william sharpe, jan mossin, and john litner. The capital asset pricing model and arbitrage pricing theory. Portfolio theory and asset pricing models portfolio theory capital asset pricing model capm efficient frontier capital market line cml security market line sml beta calculation arbitrage pricing theory famafrench 3factor model. Both the capital asset pricing model capm and the arbitrage pricing theory apt are methods used to determine the theoretical rate of return on an asset or portfolio, but the difference between apt and capm lies in the factors used to determine these theoretical rates of return. Modern portfolio theory, the capital asset pricing model.
We analyze the arbitrage pricing theory apt model and the capital asset pricing model capm and we compare the performance between them. The arbitrage pricing theory as an approach to capital asset. For this purpose, section 2 describes the basic concepts of the traditional asset pricing model, the capm, and indicates differences to arbitrage theory. Gur huberman zhenyu wang august 15, 2005 abstract focusing on asset returns governed by a factor structure, the apt is a oneperiod model, in which preclusion of arbitrage over static portfolios of these assets leads to a linear relation between the expected return and its covariance with the factors. The market portfolio the market portfolio, m, as any other portfolio, is described by portfolio weights. Arbitrage pricing theory and the capital asset pricing model. Furthermore, we exhibit the practical relevance and assumptions of these models. Ross departments of economics and finance, university of pennsylvania, the wharton school, philadelphia, pennsylvania 19174 received march 19, 1973. The capital asset pricing model capm of william sharpe 1964 and john lintner 1965 marks the bir. Arbitrage pricing theory assumptions explained hrf. Portfolio theory, capital assets pricing model capm. The arbitrage pricing theory along with the capital asset pricing model capm is one of two influential theories on asset pricing. The arbitrage theory of capital asset pricing stephen a. Assume that there exists a riskfree asset, and consider a factor model for the excess return.