1921 Words8 Pages

1. Abstract
CAPM is a capital asset pricing model for securities where it postulates a straightforward relationship between its market risk and expected return. It was introduced by William F. Sharpe and Linter in the 1960s and it sets the foundation for establishing the relationship between risk and return. Despite its popularity, it is not without limitations. As there is no one perfect solution for every problem, supplementary/alternative models (APT and three factor model) will be discussed in this essay.
2. CAPM
i. Introduction of CAPM
CAPM identifies main two aspects for which the investor should be compensated for; price of time (or time value of money; TVM) and risk premium. Price of time being, the reward for postponing spending*…show more content…*

Hence there is no accurate portfolio of the real world. Additionally, the returns are predicted future returns, which are not actual or realised returns hence the predicted returns are merely estimated. Moreover, CAPM relies on estimating beta for its equation and this beta is based on historical data which is not actual risk in the current time nor in the future. As betas tend to change overtime, it is hard to use an estimate an accurate beta. With regards to its simplistic assumptions, more variables should be taken into account to reflect the complexity of the real world. (Lewellen, 2006) Arbitrage Pricing Theory, APT is one such example of a model that seeks to take into account some variables that CAPM fail to. Another major drawback is that of CAPM being a static one period model. A popular critic of CAPM is Fama and French’s three factor model which identifies the correlation of risk with size and book-to-market*…show more content…*

APT focuses on risk factors while CAPM focuses on assets. They both rely on a linear relationship, APT is between risks and CAPM is between assets. However, some strong and unrealistic assumptions similar to that of CAPM exists in APT like all assets are available with no costs and restrictions associated with them and all investors have the same expectations and methodology. As such, though some empirical tests conducted may have concluded that APT is a superior model over CAPM, there are aspects of risks that both APT and CAPM has failed to

Hence there is no accurate portfolio of the real world. Additionally, the returns are predicted future returns, which are not actual or realised returns hence the predicted returns are merely estimated. Moreover, CAPM relies on estimating beta for its equation and this beta is based on historical data which is not actual risk in the current time nor in the future. As betas tend to change overtime, it is hard to use an estimate an accurate beta. With regards to its simplistic assumptions, more variables should be taken into account to reflect the complexity of the real world. (Lewellen, 2006) Arbitrage Pricing Theory, APT is one such example of a model that seeks to take into account some variables that CAPM fail to. Another major drawback is that of CAPM being a static one period model. A popular critic of CAPM is Fama and French’s three factor model which identifies the correlation of risk with size and book-to-market

APT focuses on risk factors while CAPM focuses on assets. They both rely on a linear relationship, APT is between risks and CAPM is between assets. However, some strong and unrealistic assumptions similar to that of CAPM exists in APT like all assets are available with no costs and restrictions associated with them and all investors have the same expectations and methodology. As such, though some empirical tests conducted may have concluded that APT is a superior model over CAPM, there are aspects of risks that both APT and CAPM has failed to

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