Capital Asset Pricing Model and Arbitrage Pricing Theory Essay

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A Chartered Financial Analyst, Jeffrey Bruner, uses the Capital Asset Pricing Model (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (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 Capital Asset Pricing Model (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 …show more content…
Here, the APT model makes a less restrictive assumption about the way investors behave. It just assumes there are at least some investors out there who would like to take extremely large positions in any risk-free arbitrage opportunities that arise. Thus, if securities are priced correctly in equilibrium, there cannot be any remaining risk-free arbitrage opportunities. APT assumes that there is perfect competition in the market, and all investors have the same expectations regarding the future in terms of mean, variance and covariance terms. Investors prefer more wealth to less wealth and short-sales are allowed. APT does not require investors to hold any particular portfolio. There is no special role for any market portfolio. Moreover, there are only systematic risk matters, but there may be several of these macroeconomic risk factors that affect the returns of well-diversified portfolios. It is up to the researcher to identify the risk factors. If any asset offers an expected return that is out of equilibrium with respect to the risk factors, then investors can build a zero wealth portfolio in order to exploit the mispricing of the security. This is known as an arbitrage in expectations. APT equation is: E(Ri) = Rf +βF1 [E(RF1)- Rf] +βF2 [E(RF2)- Rf] +…+βFK [E(RFK)- Rf]; where [E(RFK)- Rf] is the risk premium of the factor. Recall the mispriced means the