Compare and contrast the Capital Asset Pricing Model and the Arbitrage Pricing Model.
This essay is aim to compare and contrast the CAPM and APM . Both of these two model are equilibrium asset pricing model .To understand the similarities and differences between them , Firstly, we will derive and interpret CAPM and APM . Then compare them in different sides and rise the limitation of the CAPM . Finally , we will analysis whether and how the APM can avoid these problem . .
Derive CAPM and APM.
CAPM:.
"The Capital Asset Pricing Model is an equilibrium model of asset pricing, it states that the expected return on a security is a positive linear function of the security's sensitivity to changes in the market portfolio's return.".
To derive the CAPM, first we must assume away the complexities since the real world is sufficiently complex, and focus on the most important element .
These assumption are as follows:.
1. "Investor evaluate portfolio by looking at the expected returns and standard deviations of the portfolios over a one-period horizon.".
2. "Investors are never satiated, so when given a choice between two portfolio with identical expected standard deviation, they will choose the one with the higher expected return.".
3. "Investor are risk-averse, so when given a choice between two portfolio with identical expected return. they will choose the one with the lower standard deviation".
4. Individual assets are infinitely divisible , meaning that an investor can buy a fraction of a share if he or she so desire .
5. Investor may either lend or borrow money at the same risk free rate .
6. No taxes or transaction costs. .
7. Investor have same one-period horizon.
8. Information can be transmit to all investor freely and instantly .
9. Investors have same expected returns, standard deviation, and covariance of securities . (1. Sharpe ).
The CAPM becomes an extreme case by made these assumptions. All investors have same information and prospectors for the securities.
