In summary, the risk and reward relation in the CAPM is a linear relation.
Like the CAPM, the basic concept of the APT is that differences in expected return must be driven by differences in non-diversifiable risk. That is, the returns of a security are based on the systematic risk exposure of the security, as opposed to the total risk. However, the APT is not an equilibrium concept. It does not rely on the existence of a market portfolio. It is based purely on no-arbitrage conditions.
There are a number of limiting assumptions regarding the CAPM. Candidates should remember that the model assumes a perfect market that is unaffected by considerations such as transactions costs or undue influence by a single investor. Consequently, in a perfect market there would be no transactions costs, numerous investors with homogeneous expectations and the ability to borrow and lend at the risk-free rate.
Compared to CAPM, Arbitrage pricing theory (APT) is a broader based theory which states that all of the systematic factors may not be represented in the single market factor represented by the CAPM. The APT model requires fewer assumptions and considers multiple factors to help explain the risk of an asset.
The APT is a useful tool for building portfolios adapted to particular needs. For example, suppose a major oil company wanted to create a pension fund portfolio that was insulated against shock to oil prices. The APT allows the manager select a diversified portfolio of stocks that has low exposure to inflation shocks (oil prices are correlated to inflation). If the CAPM is a "one size fits all" model of investing, the APT is a "tailor-made suit." In the APT world, people can and do have different tastes and care more or less about specific factors.
The CAPM can be considered as a special case of the APT where there is only one risk factor, the market portfolio.
A. Ignores the return on the market portfolio.
B. Requires a single measure of systematic risk.
C. Ignores risk-free return.
I. allows more risk factors.
II. assumes the investors are risk-averse.
III. assumes a normal distribution of returns.
IV. has fewer restrictive assumptions.
APT does not identify the risk factors to be included in the model. If the market risk is used as the only factor, the APT would equal CAPM.
A. Investors always prefer more wealth to less wealth with certainty.
B. Capital markets are perfectly competitive.
C. A market portfolio that contains all risky assets and is mean-variance efficient.
D. The stochastic process generating asset returns can be represented as a K factor model.
A. the unique effects are independent and will not be diversified away in a large portfolio.
B. the unique effects are dependent and will be diversified away in a large portfolio.
C. the unique effects are independent and will be diversified away in a large portfolio.
A. identification of anticipated changes in production, inflation, and term structure of interest rates as key factors explaining the risk-return relationship.
The security market line equation is called the CAPM. The CAPM is a single risk factor model which attempts to predict the expected return on an asset given the expected market return and a stock's beta coefficient.
APT is a competing asset valuation model that assumes that many risk factors, other than market risk, drive stock returns. A multi-factor model, the APT relies on the assumptions: that capital markets are competitive, investors prefer more wealth to less and zero arbitrage exists. APT does not identify the risk factors to be included in the model and if only market risk is used, the APT would equal CAPM.
A. uses risk premiums based on micro variables.
I. places more emphasis on market risk.
II. recognizes multiple systematic risk factors.
III. recognizes multiple unsystematic risk factors.
IV. minimizes the importance of diversification.
A. II only
A. Once a portfolio is well diversified, all risk factors that are unique to a security will be diversified away.
Both models assume that security returns will be dependent upon some "macro" or systematic factors. Consequently, when securities are added to a portfolio, the risk factors that are unique to specific securities will offset each other until they are all diversified away.
I. Both models assert that there is a linear relationship between risk and return.
II. Both models define equilibrium as a state where all securities have the same reward to risk ratio.
III. The fundamental factors for the APT model are not known, whereas for CAPM, there is only one fundamental factor, the market portfolio.
IV. CAPM is based upon less restrictive assumptions than the APT model.
A. I and III only
II is incorrect because only CAPM defines equilibrium as a state where all securities have the same reward to risk ratio. APT, on the other hand, defines equilibrium as a state where no riskless profit may be had.
IV is incorrect because it's the other around; the APT model is based upon less restrictive assumptions than CAPM.
A. Both models state the market as a whole is a factor that will influence specific security returns.
In general, while the CAPM states that the market portfolio only influences the security return, the APT model considers that many more factors, other than the market portfolio, can influence security returns. CAPM then can be though of as a subset version of the APT model. Furthermore, because APT considers many more factors that influence security returns, it would have a greater predictive power in forecasting individual security returns than would CAPM.