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.

The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are both pivotal theories in the realm of financial economics, particularly in the context of pricing risky assets and determining the relationship between expected return and risk. Both models aim to explain the pricing of assets in financial markets but do so using different approaches and assumptions.

Comparison of CAPM and APT:

1. Basic Framework:

• CAPM: The CAPM is a single-factor model, which suggests that the expected return on a risky asset is determined by its sensitivity to the overall market return. The model posits that the only relevant risk is systematic risk, which cannot be diversified away. It introduces the concept of beta (β), a measure of the asset’s sensitivity to market movements. The formula for the expected return is given by:

E(Ri)=Rf+βi(E(Rm)−Rf)E(R_i) = R_f + \beta_i(E(R_m) - R_f)

Where:

• E(Ri)E(R_i) is the expected return _______ ____ ________ _______ __________ ___.
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