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The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two foundational models in the field of Security Analysis and Portfolio Management that aim to explain the relationship between risk and expected return for risky assets. Both models provide frameworks to determine the expected return on an asset, but they differ significantly in their assumptions, inputs, theoretical foundation, and practical application. Understanding their similarities and differences is essential for investors, portfolio managers, and financial analysts. CAPM is based on the idea that the expected return on a security is related to its sensitivity to the overall market risk, which is measured by beta. The formula of CAPM is: E(Ri) = Rf + βi (E(Rm) - Rf) where E(Ri) is the expected return on the asset, Rf is the risk-free rate, βi is the beta of the asset (a measure of its sensitivity to market movements), and E(Rm) - Rf is the market risk premium. In contrast, APT is a multi-factor model that allows multiple sources of systematic risk to affect asset returns. The expected return under APT is a linear function of various macroeconomic factors or theoretical variables that influence asset prices. The formula is: E(Ri) = Rf + βi1F1 + βi2F2 + ... + βinFn where F1, F2, ..., Fn are different factors representing various types of systematic risk, and βi1, βi2, ..., βin are the sensitivities of the asset to each of these factors. One key difference between the two models lies in their assumptions. CAPM assumes the existence of a risk-free rate, frictionless markets, rational investors who seek to maximize utility, and a single-period investment ____ _________ _________ ___ __________ ___ _________.
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