Generally speaking APT performs better in empirical contexts, however you have to decide for yourself what relevance academic studies have to your investment decisions. For instance, CAPM makes many assumptions, some of which are difficult to justify in the real world. To give one example, CAPM assumes all individuals can borrow and lend at the risk-free rate, which is in practice the rate the US government can borrow at. APT relaxes many of these assumptions, so can be seen as preferable on the basis of being more realistic. Note that f’n is the unanticipated change in the factor or surprise factor, e is the residual part of actual return. Theoretically speaking, CAPM or APT analysis may lead to lower risk as investors use set mathematical formulae.

This assumption is critical because transaction costs can significantly impact arbitrage profits and therefore alter the theory’s effectiveness. One of the key assumptions in the Arbitrage Pricing Theory is that investors have access to unrestricted amounts of borrowing and lending at the risk-free rate. Essentially, this assumption allows investors to leverage their positions to the maximum potential without any restrictions or additional costs.

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However, the APT does not provide insight into what these factors could be, so users of the APT model must analytically determine relevant factors that might affect the asset’s returns. On the other hand, the factor used in the CAPM is the difference between the expected market rate of return and the risk-free rate of return. As is well known, the CAPM prices the riskiness of an individual asset in terms of its covariance with the market portfolio. By contrast, the APT prices assets in terms of an underlying set of risk factors. The CAPM typically exploits the implications of expected utility maximization with respect to end-of-period wealth whereas the APT has been derived based on absence of arbitrage arguments. We describe the alternative sets of assumptions under which these approaches can be derived, and compare their implications with the general equilibrium approach to asset pricing.

1. Hundreds of markets all in one place – Apple, Bitcoin, Gold, Watches, NFTs, Sneakers and so much more.
2. On the other hand, it is not always possible to know the right factors or to find the right data, which is when CAPM may be preferred.
3. As a result, firms are increasingly turning to these strategies to optimise their financial performance.

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The right choice of factors to include is not necessarily constant across assets or over time. If you are pricing a portfolio, you may need to devise a different APT model for each asset if your objective is to maximize accuracy. Likewise if you return to an APT model after a few months, you need to consider whether the factors you have used still make sense.

The Arbitrage Pricing Theory Model

Essentials of financial markets, such as commodities, currencies, and stocks, often demonstrate the APT principle in practice. In essence, this has vast implications on the way investors follow various strategies to minimize risk and maximize potential returns. Despite difference between capm and apt its theoretical appeal, executing APT in real-world conditions can prove to be difficult due to the complexities in identifying and quantifying the multiple relevant risk factors on a continuous basis.

This had been proposed by Sharpe (1864) and Lintner (1965) and has been widely regarded as a foundational model within asset pricing. It posits that the expected return of an asset is determined by its beta, which measures the sensitivities of the asset’s returns to the overall market returns. According to this model, the higher the risk levels of an asset ae relative to the market, the higher the expected returns should be. It assumes that investors are rational, risk-averse, and have homogenous expectations, and that all relevant information is reflected in stock prices (Fama, 1970). Arbitrage Pricing Theory (APT) is a financial model that calculates a security’s expected return based on its relationship with multiple factors, such as macroeconomic variables or market indexes. It assumes that the price of a financial asset reflects a few key sensitive factors and maintains that an asset’s returns can be predicted by considering their sensitivity to these factors.

This allows for a more accurate assessment of an asset’s risk and expected return, leading to better investment decisions. CAPM assumes that the market is perfectly efficient, meaning that all relevant information is reflected in the prices of assets. It also assumes that investors are rational and risk-averse, seeking to maximize their utility. On the other hand, APT assumes that multiple factors influence asset returns, and these factors are not necessarily related to the market. It does not require the market to be perfectly efficient and allows for the presence of arbitrage opportunities. While both APT and CAPM explore the relationship between risk and expected returns, APT is a multifactor model that considers multiple risk factors, whereas CAPM is a single-factor model that focuses on market risk.