This paper "APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model" focuses on these models which are applied in the assessment of any given investment’s expected returns and risks going in tandem. In both, formulas are used in the determination of the required rate of return. …
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Therefore, if beta equals 1 this stock is equally risky with the market if it is 2 the same stock is twice risky in comparison to the market. While on the other hand, APT utilizes individual factors in place of beta. Also APT does not apply the market return rate and thus considered to be more particular to a given stock in focus. CAPM’s data is objective while APT applies data from a single stock. Thus, CAPM is recommendable to an investor who is relatively dormant as compared to APT, which if correctly applied is better placed to assess projects. (Grover, 2010)
Some authors have applied APT and compared the resultant estimates with those of CAPM. Patterson notes one of the cases where such has been done is the electric utility’s, written by Ross and Roll in their 1983 book. According to Patterson the end results of APT were credible in comparison to those of CAPM. But, this was without enough justification for the results. (Patterson, 1995 p151)
Besides the first two, there are methods of assessment like the Dividend Growth Model and Modern Portfolio Theory. The Dividend Growth Model shows the value of ordinary shares in a present value of the prospected future flows of cash which has been invested by an investor. The receivable cash inflows are taken as dividends as well as the expected price in future while the stock will be disposed of. An ordinary share usually does not possess the maturity and thus, it is held for numerous years. Therefore, a general ordinary shares’ valuation introduced by Gordon would be as below;
Just to mention, the other model investment assessment is known as MPT- Modern Portfolio Theory. This is a theory applied by investors who are risk averse and at the same time, they want to achieve maximum or optimum level of expected return which is based on the market risk level. It emphasizes that risk is inherent in the process of getting the rewards associated with it.
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Risk free rate + ? (Average Market Return –Risk free rate) Where ? is the beta value of the financial asset The basic assumptions of this model pose as disadvantageous for this model to be considered as a perfect representative of required return calculation.
The capital asset pricing method offers some productive concepts. According to this concept, the investors have to be compensated on the strength of their time value of money and risk. Time value of money represents the period of time an investor placed his money in any investment.
The author explains Arbitrage pricing theory, which does not depend on the performance of the market; it takes into account the fundamental factors that drive the price of the security. Unfortunately, theory does not provide any indication of what these fundamental factors are; instead, they need to be found empirically.
APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model alike are methods applied in the assessment of any given investment’s expected returns and risks going in tandem. In both, formulas are used in the determination of the required rate of return for a given investment in order it be considered worthwhile.
The Capital Asset Pricing Model (CAPM)
For an open market place, an idealized framework is assumed. In this market, stocks available for trade are assumed to risky assets. Moreover, there are also those assets that are not associated to any risk and customers borrow whichever the quantity they want since there are no stipulations limiting quantities to be borrowed.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
The CAPM model therefore relies on the ability to measure market volatility as a whole. With several possible investments available in the market, the model assumes that one can accurately assess the volatility of each of these investments. This is impossible.
According to the CAPM, the relation between the expected return on a given asset i, and the expected return on a proxy market portfolio m is given as:
APT holds that the expected return of a financial asset can be modelled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient.
CAPM stands for capital asset pricing model (CAPM) which is used for relating the risk and the associated trade-offs with market returns. The security price is associated directly with the cost of the capital. However, the interest rates can be used in relation to the cost of capital while the beta is used as a proxy for the level risk.
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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