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Apt & Capm

In: Business and Management

Submitted By toludelight
Words 985
Pages 4
INTRODUCTION
Based on the law of one price, two items that are the same cannot sell at different prices, when this occurs arbitrage takes place and the arbitrageurs buy the cheaper goods and sell the higher priced goods till all the prices of the goods are equal. Arbitrage Pricing Theory describes a mechanism used by investors to identify an asset, such as a share of common stock, which is incorrectly priced.
On the other hand the Capital Asset Pricing Model is based on a comparison or the systematic risk/market risk of individual investment with the risk of all shares in the market. It is also used to calculate cost of equity and incorporates risk.
ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory was developed by the economist Stephen Ross in 1976. Arbitrage Pricing Theory assumes that each stock’s return to the investor is influenced by several independent factors. The APT model also states that the risk premium of a stock depends on two factors: The risk premium associated with each of the factors The stock’s sensitivity to the factors similar to the beta concept
This theory does not tell the investor what those factors are for a particular stock or asset; in theory one stock might be more sensitive to one factor than another. Arbitrage leaves it up for the investor or fund manager to identify each factor for a particular stock. Hence the real challenge is for the fund manager to identify Each of the factors affecting a particular stock The expected returns for each of these factors The sensitivity of the stock to each of the factors( Note: the sensitivity of a stock is likely to change overtime)
Ross and others identified the following macro-economic factors they felt played a significant role in explaining the return of a stock: Inflation GNP or Gross National Product Investors’ Confidence Shifts in the Yield Curve

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