The Capm and Apt; Does One Outperform the Other?

Before making comparison between the CAPM and APT, we should first see what they are about.

The CAPM is a theory about the way how assets are priced in relation to their risk. The CAPM was brought about to answer the question which came from Markowitz’s

mean-variance portfolio model. The question was how to identify tangency portfolio. Since then, the CAPM has developed into much, much more. CAPM shows that equilibrium rates of return on all risky assets are a function of their covariance with market portfolio. APT is another equilibrium pricing model. The return on any risky asset is seen to be a linear combination of various common factors that affect asset returns. These two models in fact are similar to each other in some way.

CAPM Assumptions:

• Investors are risk averse individuals and they maximise their expected utility of their end of period wealth. They have the same one period of time horizon.

• Investors are price takers (no single investor can affect the price of a stock) and have homogenous expectation about asset returns that have a joint normal distribution.

• Investors can borrow or lend money at the risk-free rate of return.

• The quantities of assets are fixed. All assets are marketable and perfectly divisible.

• Asset markets are frictionless and information is costless and simultaneously available to all investors.

• There are no market imperfections such as taxes, no transaction costs or no restrictions on short selling.

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As we can see, many of these assumptions behind the CAPM are not realistic. Although these assumptions do not hold in the real world, they are used to make the model simpler for us to use for financial decision making. Most of these assumptions can be relaxed.

The CAPM requires that in equilibrium the market portfolio must be an efficient portfolio. As long as all assets are marketable, divisible and investors have homogenous expectations, all individuals will perceive the same efficient set and all assets will be hold in equilibrium. If every individual holds a percentage of their wealth in efficient portfolios, and all assets are held, then the market portfolio must be also efficient because the market is simply the sum of all individual holdings and all individual holdings are efficient. Without the efficiency of the market portfolio the capital asset pricing model is untestable. The efficiency of market portfolio and the CAPM are inseparable joint hypothesis.

EI=EF +(EM – EF)βi βi= Covim / Vm = σim / σ2m

β is quantity of risk; it is the covariance between returns on the risky asset, I, and the market portfolio,M, divided by the variance of the market portfolio.

If we show how to derive the CAPM equation in a simple way:

M:Market portfolio, EF:Riske free rate, I:Risky asset

The straight line connecting the risk-free asset and market portfolio is the capital market line. In equilibrium the market portfolio will consist of all marketable assets

held in proportion to their value weights.

The equilibrium proportion of each asset in the market portfolio must be;

wi=Market value of individual asset / Market value of all assets

A portfolio consisting of a % invested in risky asset I and (1-a) invested in the market portfolio will have the following mean and standard deviation;

EP= aEI +(1-a)EM , SP={a2VI+(1-a)2VM+2a(1-a)CovIM}1/2

VI: The variance of the risky asset I and

CovIM: The covariance between asset I and the market portfolio.

The opportunity set provided by various combinations of the risky asset and the market portfolio is the line IMI’ in figure 1.To determine the equilibrium price for risk at point M in figure 1:

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Evaluating dEP/da at where a=0 gives us =EI-EM

dSP/da where a=0 gives us (CovIM-VM)/SM

In equilibrium the market portfolio already has the value weight, wi percent, invested in the risky asset I. The percentage a is the excess demand for an individual risky asset. In equilibrium excess demand for any asset must be zero.

dEp/da at a=0 is equal to (EI-EM)

dSp/da (CovIM-VM)/SM

This is the slope of the efficiency frontier.

At equilibrium the slope of the opportunity set

at point M,is equal to capital market line;(EM-EF)/SM .

At equilibrium (EM-EF)/SM = (EI-EM)

(CovIM-VM)/SM

We solve this for EI

EI=EF+(EM-EF)CovIM/VM or EI=EF+(EM-EF)β

(See Copeland/Weston and Elton/Gruber for detailed proof how to derive the CAPM).

Equation above is known as the capital asset pricing model .It is shown in the figure 2 where it is also called security market line. Security market line depicts the trade-off

between risk and expected return for individual securities.

The CAPM equation above describes the expected return for all assets and portfolios of assets in the economy .Em(market return) and Ef(return on riskless asset) are not functions of the assets we examine. Thus, the relationship between the expected return on any two assets can be related simply to their difference in β.The higher β is for any security, the higher must be its equilibrium return. Furthermore the relationship between β and expected return is linear. This equation tells us something important that β (systematic risk) is the only important element in determining expected returns and non-systematic risk plays no role. Thus, the CAPM verify what we learned from portfolio theory that an investor can diversify all the risk except the covariance of the risk with market portfolio. Consequently, the only risk which investors will pay a premium to avoid is covariance risk.

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We made many assumptions for the CAPM. Are all these assumptions realistic? The CAPM may describe equilibrium returns on macro level, but from individual investor’s perspective, we all hold different portfolios. Therefore it can not be exactly true. Alternative versions of the CAPM have been derived to take into account these problems which violate its assumptions. Modifying some of its assumptions leaves the general model unchanged, whereas changing other assumptions leads to the appearance of the new terms in the equilibrium relationship or, in some cases, to the modification of old terms. However we should be careful, when we change assumptions simultaneously, the departure from standard CAPM may be serious (see Elton/Gruber).

There has been many empirical testing of the CAPM model(There are some problems inherent in the test of CAPM).To test the CAPM we must transform it from exante form to the expost form that uses observed data.

When CAPM is tested, it is generally written in this form:RI=δ0+ δ1βI+εI

RI=RF+(RM-RF) βI+εI

(RI-RF)=(RM-RF) βI+εI , δ1 =RM-RF

RI=the excess return; (RI-RF)

Conclusions from empirical tests;

Estimated δ0 is not equal zero, estimated δ1

Tests shows that beta risk dominates the risk.The simpler linear model which is RI=δ0+ δ1βI+εI fits the data best.It is linear also in β.

They also found out that factors other than β are successful in explaining that part of security returns not captured by β. They also found out that price/earning ratios, size of the firm, management of the firm and other factors have effect in explaining returns.These showed there are other factors other than β explaining returns.

We should mention Roll’s critique quickly; Roll pointed out that There is problem

With testing efficient portfolio(Remember the Joint hypothesis).Roll said that there is nothing unique about the market portfolio.You can choose any efficient portfolio or an index(if performance is measured relative to an index),then find the minimum variance portfolio that is uncorrelated with the selected efficient index.If index turns out to be ex-post efficient,then every asset will exactly fall on the security market line.There will be no abnormal returns.If there are systematic abnormal returns, it simply means that the index that has been chosen is not ex-post efficient. Roll argues that tests performed with any portfolio other than the true market portfolio are not tests of the CAPM. They are simply tests of whether the portfolio chosen as a proxy for the market is efficient or not. Since over an interval of time efficient portfolios exist, a market proxy may be chosen that satisfies all the implications of the CAPM model, even when the market portfolio is inefficient. On the other hand, an inefficient portfolio may be chosen as proxy for the market and the CAPM rejected when the market itself is efficient. What Roll says, that we do not know the true market portfolio. Most tests use some portfolio of common stocks as the market, but the true market contains all risky assets (marketable and non marketable, human capital, coins, buildings, land etc).

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APT offers a testable alternative to the CAPM. The CAPM predicts that security rates of return will be linearly related to a single common factor; the rate of return on the market portfolio. APT has similar assumptions as CAPM has, like perfectly competitive markets, frictionless capital markets, and assumption of homogenous expectations. APT replaces CAPM’s assumption which is based on mean variance framework by assumption of the process generating security returns.

Returns on any stock linearly related to asset of indices as shown below:

Ri =αi+bi1I1+bi2I2+……+binIm+εi , αi=E(Ri)

Im=the value of the index that affect the return to asset i;macro economic factors,size of firm,inflation,etc).

bin=the sensivity of the ith asset to the nth factor.

εi=a random error term with mean equal to zero and variance equal to σ2ei

In APT, We assume that covariances that exist between security returns can be attributed to the fact that the securities respond to one degree or another pull of one or more factors. We assume that the relationship between the security returns and the factors in linear. According to APT, in equilibrium all portfolios that can be selected from among the set of assets under consideration and that satisfy the conditions of (a)using no wealth and (b)having no risk must earn no return on average. These portfolios are called arbitrage portfolios.

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... returns of the stocks. Table 6: APT Results for Industry Portfolios For the IT portfolio, the betas for the risk premium and the industrial production factors ... beta and the security market line for the same securities (CAPM risk-return equation). They find two very contrasting sets of results from ...

Let’s see a simple proof;

wi = change in wealth in invested in asset i, as a percentage of an individual’s total wealth,Σwi=0

Rp= ΣwiRi= Σwi(αi+bi1I1+bi2I2+……+binIm+εi)

To eliminate risk( diversiable and undiversiable) and get a riskless arbitrage portfolio;(1)choose small wi; percentage changes in investment ratios(2) diversify in a large number of asset in portfolio.

Σwi bik=0, k=1,2….n. wi must be small, i must be large.

wi≈1/n (n chosen to be a large number), Σwi bik=0 (this elimanetes all systematic risk).

Consequently, the return on our arbitrage portfolio becomes a constant. Correct choice of the weights has eliminated all uncertainity, so that RP is not a random variable. RP becomes; Rp= Σwi αi

If the individual arbitrageur is in equilibrium, then return on any arbitrage portfolio must be zero.

Rp= Σwi αi =0

Σwi=0 , Σwi bik=0 , Rp= Σwi αi =0= ΣwiE(Ri)

These equations are statements in linear algebra.

w e=0, w b=0 , w α=0 ,underlined w,b, α are vectors.e is the constant vector.

α must be linear combination of e and b, α must be orthonogol to e and b as well.

α or E(Ri) must be linear combination of the constant vector and the coefficient vector.There must exist a set of k+1 coefficients, λ0, λ1,….. λk.

αi =E(Ri)= λ0 +λ1bi1+……+ λkbik , ( remember bik are the factor loadings;sensivities of the returns on the ith security to the kth factor).

If there is a riskless asset with a riskless rates of returns;RF then, bik=0 and RF= λ0

Rewrite the E(Ri) in excess returns form;

E(Ri)- RF= λ1bi1+……+ λkbik, this is the APT equation. E(Ri)- RF is excess return on risk free asset.

λ k = risk premium;price of risk in equilibrium for the kth factor.

λ k=δk-Rf , δk; is expected returns on a portfolio with the unit sensitivity to the kth factor and zero sensitivity to all other factors. And so risk premium, λ k ,is equal to the difference between the expectation of a portfolio that has unit response to the kth factor and zero response to the other factors and Rf.

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We can now rewrite APT equation in the following form;

E(Ri)- RF=[ δ1-Rf ] bi1+[δ2-Rf] bi2+……..+[ δk-Rf] bik

If this equation is interpreted as a linear equation, then the coefficients bik ,are defined in the same way as beta in the CAPM model; bik=Cov(Ri, δk)/Var(δk).

Beta here will give relation of i to various factors.

The APT seems to be stronger than the CAPM;

• APT makes no assumptions about the distribution of asset returns. CAPM assumes that the probability distributions for portfolio returns are normally distributed.

• The APT does not make any strong assumptions about utility function(only risk averse).According to the CAPM investors are all risk averse individuals who maximise their expected utility of their end of period wealth.

• The APT allows the equilibrium returns of assets to be dependent on many factors not just one.

• The APT produces a statement about the relative pricing of any subset of assets; we do not need to measure the entire universe of assets in order to test the theory.

• There is no special role for the market portfolio in the APT, whereas the CAPM requires that the market portfolio be efficient.

Before we go into detailed discussion of the two models, we should quickly mention some empirical tests about APT itself and its comparison with CAPM.

Factor analysis is used in first empirical tests of APT. One problem with any approach to testing the APT is that the theory itself is completely silent with respect to the identity of the factor structure that is priced.

Chen,Roll,Ross(1983) found that a collection of four macroeconomic variables that explained security returns fairly well. But Dhrymes, Friend, Gultekin (1984) point out that the more stocks you look at, the more factors you need to take into account.

Chen(1983) compared CAPM and APT. First APT model was fitted to the data as in the following equation; Ri = λ^0 +λ^1bi1+……+ λ^kbik+εi (APT)

The CAPM was fitted to the same data;Ri= λ^0 + λ^1βi+ηi (CAPM)

Next the CAPM residuals ηi were regressed on the arbitrage factor loadings, λ^k,and APT residuals, εi were regressed on the CAPM coefficients.The results showed that the APT could explain a statistically significant portion of the CAPM residual variance,but the CAPM could not explain the APT residuals.This shows that the APT

is more reasonable model for explaining the cross sectional variation in asset returns.

Fama,French(1992) found that Beta did a relatively poor job at explaining differences in the actual returns of portfolios of US stocks. Instead Fama and French noted that there were other variables beside beta with respect to market that explained returns. These findings were interpreted as strong indications that CAPM does not work.

Haugen(1999) tests with predictive power of APT with different factors. According to his findings APT appear to have predictive power. However, its power falls short of adhoc expected return factor models.

We so far tried to give some theoretical understanding of these two models.

Let’s go further to examine the two models;

APT has a number of benefits; it is not as restrictive as the CAPM in its requirements about individual portfolio. It allows multiple sources of risk, indeed these provide an explanation of what moves stock returns. The APT demands that investors perceive the risk sources and that they can reasonably estimate factor sensitivities. In fact even professionals and academics can not agree on the identity of the risk factors, and the more betas you have to estimate the more noise you must live with.

The CAPM is theoretically pleasing, however its biggest criticism is that it is not testable. The APT came out as a testable alternative, but its testability is an open question as well. Some would argue that models should not be judged on the basis of the accuracy of their assumptions, but rather on the basis of their predictive power. The CAPM makes a single prediction, the efficiency of the market portfolio, which has been argued to be untestable. The power of the APT in predicting future stock returns falls short of adhoc expected return factor models. The problem may well be that the arbitrage process presumed in the APT is difficult; If not impossible to implement on a practical basis.The APT calls for arbitraging away nonlinearity in the relationship between expected returns and the factor betas. We arbitrage by creating riskless stock portfolios with differential expected returns. However, you will find that it is impossible to create riskless portfolios comprised exclusively of risky securities such as common stocks.

In one important respect, both models exhibit a similar vulnerability. In the case of both models, we are looking for a benchmark for purposes of comparing the expost performance of portfolio managers,and the exante returns on real and financial investments. In the case of the CAPM, we can never determine the extent to which deviations from the security market line benchmark are due to something real or are due to obvious inadequacies in our proxies for the market portfolio. In the case of the APT,since theory gives us no direction as to the choice of factors, we can not determine whether deviations from an APT benchmark are due to something real or merely due to inadequacies in our choice of factors.As we know that the APT really makes no predictions about what the factors are. Given the freedom to select factors without restriction, it can be argued that you can literally make the performance of a portfolio anything you want it to be. In the case of the CAPM, you can never know whether portfolio performance is due to management skill or to the fact that you have an inaccurate index of the true market portfolio. Another problem with CAPM that hedging motive does not enter in it, and therefore people hold the same portfolio of risky assets. In reality people might have different tastes and, it may make sense for them to hold different portfolios.The CAPM says that investors will price securities according to the contribution each makes to the risk of their overall portfolios. This is intuitively appealing. CAPM is an accepted model in the securities industry. It is used by firms to make capital budgeting and other decisions. It is used by some regulatory authorities to regulate utility rates(e.g. electric utilities).

It is used by rating agencies to measure the performance of investment managers. The APT can also be applied to cost of capital and capital budgeting problems, but APT seems to be practically difficult for capital budgeting. There is a practical problem of the estimating the state-contingent prices of the comparison stock and the risk free asset.

If we summarize what we said so far;

APT and CAPM generally address the same basic issues:

• how should we measure the risk of a risky asset?

• how should we compute required return?

CAPM takes an oversimplified view of economy-wide news; consider a stock , according to the CAPM ,every time economy-wide news makes the market go up by 1%,we expect this stock to go up by 1% times beta of this stock. What type of economy-wide news made the market go up does not matter. The stock reacts the same way to all types of economy-wide news.

But According to the APT ,what type of economy-wide news it is should matter.For example; BP would be more sensitive to an oil factor than Coca-Cola.

CAPM assumes that a given stock is equally sensitive to different type of economy-wide news.APT assumes that a given stock has a different sensitivity to different types of economy-wide news.In the CAPM all economy-wide news is lumped together into one single equation, and stock’s beta is the sensitivity to all types of economy-wide news. The APT assumes that random returns are given by the kth factor model instead of the market model. The single term representing economy-wide news in CAPM has been broken in to k separate terms. So there are k different types of economy wide-news. bi1 is the stock i’s sensitivity to type 1 news, bi2 is stock i’s sensitivity to type 2 news. Each of these Betas are different. CAPM lumps all systematic risk together into one term; so there is a single risk premium. APT says there are k types of systematic risk, so there are k risk premiums, one for each type of systematic risk.λi1bi1 is the risk premium for type 1 risk.λi2bi2 is the risk premium for type 2 risk. Just like CAPM, bi1 is the amount of type1 risk this stock has, and λ1 is the market price for type 1 risk. The risk of a stock is measured jointly by its k betas, and then the required return is determined by the equation.

It is clear from all of our discussion that conceptually APT is an improved version of the CAPM, but why do we still use CAPM as well? Because, in practise, APT does not work better than CAPM. That happens because of estimation error. APT does not tell us how many factors we should use and it does not tell us what the factors are.

The CAPM is more simple-minded model but we can estimate βi and RM a lot more precisely, so the required return is reasonably accurate. The APT may be more advanced conceptually, but this is cancelled out by the greater estimation error. In practise, the required return we come up with is not more accurate than the CAPM.

The CAPM is simpler to understand, easier to use. The APT is more difficult to understand much harder to use. APT is rarely used for computing required return, but it has useful applications in investment management.

After seeing both models, we can say that if we choose one against the other, then in each one unfortunately you win some and you lose some. Neither can the two models outperform each other completely. Rather than trying to persuade each other, one is better than the other. We should thoroughly understand their weakness as well as their strengths, so that we will know when and how, which model we can rely on in making financial decision.

References

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Brealey,R. /Myers,S.1991. “ Principle of Corporate Finance”, McGraw-Hill.

Chen,N.F.1983,” Some Empirical Tests of theory of Arbitrage Pricing”, Journal of Finance.

Chen N, Roll R, and Ross SA, (1986).

“Economic Forces and the Stock Market”, Journal of Business.

Copeland/Weston,1988, ”Financial Theory and Corporate Policy”, Addison Wesley/Longman.

Costas Lapavitsas,2003,”Lecture Notes on Capital Markets,Derivatives and Corporate Finance”,SOAS,University of London.

Dhrymes,P.,Friend,I.,and Gultekin,N.1984.”A Critical Reexamination of the Empirical Evidence on the Arbitrage Pricing Theory,.”Journal of Finance”.

Elton/Gruber,1995, “Modern Portfolio Theory and Investment Analysis”,John Wiley&Sons,Inc.

Fama,E.F, and K.R.French,1992,”Cross-Section of Expected Stock Returns,”Journal of Finance.

Haugen,R,2001, “Modern Investment Theory”, Prentice Hall.

Jagannathan,Ravi.,Meier,Iwan. “Do we need CAPM for capital budgeting”?, Financial Managemanet.

Koppenhaver,G.D “Lecture Notes on Capital Market Theory”,Iowa State University.

Seth,S. “Lecture notes on Financial Markets”College of Business,University of Illionis.