The asset pricing models CAPM - Essay Example

For instance, if investor A buys more of stocks of X than Y, then every investor in the market will react the same by buying of stocks X and less of Y. Therefore, from this illustration and the aforementioned explanation, it is evident that the two models assumes that the investors in the market evaluate the information they have in the same way, hence arriving at the same decisions regarding their investment activities. However, given that investors have homogeneous expectations concerning their returns, level of risk inherent and investment strategies, they will always tend to remain risk averse (Sharpe, 1964).

From the explanation above, it is clear that the models of APT and CAPM depend on the publicly available information concerning the returns and level of risk inherent in specific securities (Watson and Head, 2007). Therefore, the models do not specify any particular information that investors should use regarding their investment decisions but assume the investor will use the most current information available in the market concerning the different securities, thus, helping them choose the best investment strategies.

The proponents of the APT argue that the model is the best alternative to the CAPM because it has more assumptions requirements that are flexible (Reilly & Brown, 2011). For instance, whereas the capital asset pricing model uses the expected return of a security, APT uses a security’s risk expected return, in addition to, the risk premiums of a couple of macro-economic elements. Therefore, from this proposition it is undeniable that CAPM has more strong assumptions compared to the APT. For instance, whereas the CAPM assumes that there exists a risk free rate in the market, the APT model tries to identify risk premium to enable investors take advantage of any mispriced securities, which is different from the