Capital Asset Pricing Model ( Capm ) And Arbitrage Pricing Theory Essay

Capital Asset Pricing Model ( Capm ) And Arbitrage Pricing Theory Essay

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Introduction
This report discusses about the strengths and weaknesses two types of asset pricing theory - Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). The CAPM model shows the relationship between the fair expected returns and the systematic risk of a portfolio. Figure 1 shows the formula of CAPM.






The APT model also shows the relationship between the fair expected returns and risk in line with the law of one price, taking into account both systematic and unsystematic risks. Figure 2 shows the APT formula.

Figure 2







CAPM- Strength
CAPM includes systematic risks in its calculations. Systematic risks are risks that are caused by macroeconomic factors like war, recession, inflation, interest rates, etc. Systematic risks are not included in other returns calculation models like the Dividend Discount Model. It is necessary for an investor to recognise the volatility of his stock due to the systematic risk compared to the market returns, in order to demand for an appropriate return from that stock. The trade-off between systematic r...

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