Question

Explain efficient market hypothesis

similarities and differences between CAPM and APT

Answer 1

1) The efficient market hypothesis states that information is universally available and hence market participants are aware of the same. This will lead to the fact that stock prices will reflect all the news and events in itself in an effective manner. According to this theory the prices of stock market moves on current news instead of yesterday's trends. Basically, trends do not matter under efficient market hypothesis, because prices are driven by current information, news and events which are already 'priced in' within current stocks and their prices. Under the strong form of theory, it can be assumed that there is perfect transparency of information and future movement of stock prices are independent of the past movements, but are based on current news and information.

2) The CAPM stands for Capital Asset Pricing Model and APT stands for Arbitrage Pricing Theory. Both the theory are being used for the purpose of determining theoretical rate of return on a portfolio or a particular asset. The similarities and differences between the two theories can be laid down as follows:

Similarities

• Both of the theories are used to calculate theoretical rate of return on an asset or a particular stock.
• Both are based on certain assumptions, which, if holds true, then only both theories are useful.
• They both provides benchmarks in order to generate fair rate of return
• They both tends to agree on a relationship between the beta of the stock and the return it generates

Differences

• APT only applies portfolios which are diversified in nature
• There is no guarantee that equilibrium expected relationship of return as well as beta of stock will hold good for assets.
• CAPM applies to all assets without reservation
• APT has less assumptions than CAPM