Compare and Contrast Capital Asset Pricing Model (CAPM) with Arbitrage

Question

Compare and Contrast Capital Asset Pricing Model (CAPM) with Arbitrage Pricing Theory (APT). Which of the two is a better model for pricing risky assets and why, explain with reasons.

26 Oct 2021

Answer :

Word Count : 470

Security Analysis and Portfolio Management are crucial aspects of finance that involve evaluating and managing investments to optimize returns and minimize risks. The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are two prominent approaches used to estimate the expected returns of risky assets. Let's delve into a detailed comparison and contrast between these models to determine their respective strengths and weaknesses.

Capital Asset Pricing Model (CAPM):

CAPM is a widely-used model that establishes a linear relationship between the expected return of an asset and its systematic risk, measured by beta. The formula for CAPM is:

\[E(R_i) = R_f + \beta_i (E(R_m) - R_f)\]

Where:
- \(E(R_i)\) is the expected return on the asset.
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