Question

Compare and contrast Capital Asset Pricing Model (CAPM) with Arbitrage Pricing Theory (APT). What is the single most important issue with CAPM? Which model is more realistic? Why?

Answer 1

The Capital asset pricing model assumes a constant risk free rate (rf) and the calculates the return of the security in terms of the risk and the overall market return.

The rate of return of a security is calculated as: Rf + Beta*(Rm - Rf) where Rf is the constant risk free rate, the beat is the measure of risk associated with the business. The Rm is the market return of the board market.

The arbitrate pricing theory (APT), on the other hand says that the return is based on several risk factors. Some of the risk factors are macroeconomic variables like inflation, interest rate cycle, the GDP growth rate and some micro factors of the business. So its various risk factors against just a single risk measure,

The single most important issue is that the model assumes a constant risk free rate, but in reality the risk free rate which is the T-bill rate changes on a daily basis. The APT is more realistic because it considers more risk factors. But when we talk simplicity and ease of use, the CAPM is better.