Question

According to CAPM, there is linear relationship between the assets but APT assumes linear relationship between the risk factors.

APT- Arbitrage Pricing Theory is a method of estimating the price of the assets. This theory is based on macroeconomics, market and security specific factors.

Formula- E(r_j) = r_f + b_j1 RP₁ +b_j2 RP₂ + b_j3 RP₃.......

Where E(r_j) = Asset's expected rate of return, r_f = risk free rate, b_j = the senstivity of the asset's return to the factor, RP = the risk premium associated with the factor.

CAPM- Capital Asset Pricing Model tells the relationship between risk and expected return. It is used in pricing of securities that are risky in nature. It says that the expected return of a portfolio is equal to the risk free rate of return and the risk premium.

Formula- r_a = r_f + Beta (r_m - r_f)

Where  r_a = expected return, r_f = risk free rate, r_m = expected market return.

I am not sure what is the exact risky factors here, meanwhile what is the asset in the CAPM model? Cheers

Answer 1

The risky factors here mean the factors that influence the change in expected return and the actual return. These include changes in market conditions, changes in the economy of a country, the financial results of the company and the like. These risks include systematic and unsystematic risks. Systematic risks are those that cannot be mitigated and have to be included while assessing return. Unsystematic risks those that can be reduced by diversification of a portfolio.

Assets in CAPM is to means the securities held in the portfolio of an investor i.e. stocks, bonds, T-bills among others.