Arbitrage Pricing Theory

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The Capital Asset Pricing Model is not the only asset pricing model around. One of the competing approaches to asset pricing is called the Arbitrage Pricing Theory, which was developed to address some of the criticisms of the CAPM.

The CAPM is not inconsistent with the APT. Although its intellectual foundations differ, the two theories are basically arguments that the expected return of a security (i.e. the appropriate discount rate for its cash flows!) is a linear function of systematic risk. The major difference in practice between the CAPM and the APT is that the CAPM uses one risk variable, the market portfolio, while the APT uses several, which is largely the reason why I'm partial to the APT. The APT factors are typically macro-economic - they are related broadly to the economy. None the less, these factors will also affect the market portfolio. Thus, when you use the CAPM, the one single factor will reflect the variation in the APT factors.

The CAPM is a classical model in finance. It is an equilibrium argument that, if true, answers most important investment questions. It tells us where to invest, how to invest and what discount rate to use for project cash flows. Not only that, it is a disarmingly simple model. The expected return of a security depends upon a simple statistic: à?. The relationship between risk and return is linear. Calculation of portfolio risk is trivial. At the same time, the CAPM is revolutionary. It tells us that the variance of a project is NOT a factor in determining the appropriate, risk-adjusted discount rate. It turns financial research from roll-up-your-sleeves fundamental analysis into a statistics problem. In short, the CAPM turned Wall Street on its head.

Here comes the bad news. Despite twenty years of attempts to verify or refute the Capital Asset Pricing Model, there is no consensus on its legitimacy. There are a few hints that the model is ...