CAPM vs. APT: Do you think APT or the CAPM is the best approach for a financial professional to use?

Subject  > Businesss Research Papers  > Accounting

In an effort to overcome some of the criticisms and weaknesses of the CAPM, an alternative pricing theory called the arbitrage pricing theory (APT) has been advanced. It was originally developed by Stephen Ross (1976) as 'a related but quite distinct theory' to CAPM of the risk-return relationship. Ross (1976) contended that the APT model is: 'substantially different from the usual mean-variance analysis and constitutes a related but quite distinct theory'. He maintained that APT differs from CAPM in two major ways. First, APT is a multi-factor model while CAPM is a single-factor model. Second, unlike CAPM, the APT model does not require the market portfolio to be mean-variance efficient (i.e. to offer the best risk-return combination) and alternatively assumes that ...

... of required returns and variance. However, the APT model is much more complex than CAPM and is theoretically unclear about the nature and number of relevant risk factors. Moreover it is very difficult to establish each factor's risk premiums and to measure their sensitivity coefficients. This makes the model almost impossible to put into practice. To date, the APT model is still in its relative infancy. The empirical work which has so far been done does not provide any conclusive results on the efficacy of the model. In conclusion, both the APT and CAPM do offer us alternative conceptual frameworks for trying to understand the connections between risk and return and thus the task of

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