Risk Management - CAPM Term Paper

Pages: 8 (2664 words)  ·  Style: Harvard  ·  Bibliography Sources: 25  ·  File: .docx  ·  Level: College Senior  ·  Topic: Economics

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Finally, the CAPM assumes that the variables are constant, whereas market history has shown that their value changes throughout time (ACCA Trainer, 2008).

In spite of these limitations however, CAPM is credited for some strengths. For instance, it is well praised for having introduced the constructions of the systematic risk, the diversifiable risk, the market portfolio or beta (Fabozzi, Markowitz, 2002). Another advantage is that of the sole inclusion of the systemic risk, revealing as such the realities of the modern day financial community, in which the invertors have diversified their portfolios. Third, the CAPM constructs a theoretical relationship between the required return and the systematic risk, relationship which can be usefully applied in other models and financial computations. Then, it retrieves superior quality results in not only share pricing and risk, but also in terms of the cost of equity and investment appraisals -- the quality of the end results is superior to that of the results retrieved through models such as the Dividend Growth Model or the Weighted Average Cost of Capital (ACCA Trainer).

The Arbitrage Pricing Theory has the major benefit of being more flexible than the CAPM, in the meaning that it is constructed on more flexible assumptions. This is a strong reason as to why some investors replace the CAPM with the APT. Additionally, it is safe to argue that the applicability of the APT within the modern day context is more increased than that of the CAPM.

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The APT however also manifests some disadvantages, the most important of them being generated by the complexity of the formula and the calculi involved. Since the model assumes the existence of numerous non-company factors, it uses a large number of betas.

6. Differences and Similarities

The best means to comparatively assess the Capital Asset Pricing Model and the Arbitrage Pricing Theory is that of pointing out the two models' commonalities and differences. In this order of ideas, CAPM and APT are similar due to the following elements:

They are both focused on addressing issues related to organizational assets

They are both constructed on several assumptions

Term Paper on Risk Management - CAPM and Assignment

Some underlying assumptions overleap and are recurrent for moth models -- such as the homogenous expectations of investors or the perfect markets

In both scenarios, the final return expected to be generated by a risky investment is composed from the risk free rate and the reward for taking on the additional risk (Elmhurts College Center for Business and Economics)

Both models have a long existence and have been continually developed and improved

Despite these similarities, CAMP and APT however differ when it comes to the following aspects:

The strength of the assumptions onto which they are constructed differs in the meaning that the assumptions of CAPM are rather strict and rigid, whereas those for APT are more flexible

In terms of the number of assumptions, these are fewer for APT than in the case of the CAPM

This leads to the second difference, in terms of applicability -- the CAPM is less applicable in today's context, whereas the APT can easily find applicability

A next major difference is the usage of beta. While CAPM uses a single beta, as it builds on the existence of a single non-company factor, the APT is constructed on the existence of numerous factors, meaning then that it uses more betas (Money Terms, 2009)

This translates into a different complexity of the calculi to be conducted, in the meaning that the CAPM is simpler to be implemented, whereas the APT is more complex

The CAPM is generally more popular and more widely used, but is also more criticized; the APT is less commonly used, it is generally considered superior to the CAPM

7. Conclusions

The individuals activating in the modern day financial sector are presented with incremental challenges, but also with more and more opportunities. In terms of asset management, individual investors are able to quantity the worth of investing in a share, and as such maximizing the profitability of their portfolio and minimizing the adherent risks. Two means in which this desiderate is achieved are organized under the generic names of the Capital Asset Pricing Model and the Arbitrage Pricing Theory. Both theories are constructed on sets of assumptions, with the general opinion being that the APT assumptions are more realistic than those of the CAPM.

The two models reveal both similarities as well as differences. Additionally, they both raises praises as well as criticism. The final choice lays in the hands of the individual investor, who selects the most adequate model based on his own assumptions and the characteristics of the market and his own portfolio.

References:

Bailey, R.E., 2006, The Economics of Financial Markets, Cambridge University Press, ISBN 052184827X

Cheng, B., Tong, H., 2008, Asset Pricing: A Structural Theory and Its Applications, World Scientific, ISBN 9812704558

Fabozzi, F.J., Markowitz, H., 2002, The Theory and Practice of Investment Management, John Wiley and Sons, ISBN 0471228990

Fabozzi, F.J., Focardi, S., Kolm, P.N., 2006, Financial Modelling of the Equity Market: From CAPM to Cointegration, John Wiley and Sons, ISBN 0471699004

Huberman, G., Weng, Z., 2005, Arbitrage Pricing Theory, Columbia Business School, http://www0.gsb.columbia.edu/faculty/ghuberman/APT-Huberman-Wang.pdf last accessed on November 27, 2009

Jones, C., 2008, Financial Economics, Taylor and Francis, ISBN 0415375851

Levy, H., Sarnat, M., 1994, Capital Investment and Financial Decisions, 5th Edition, Pearson Education, ISBN 0131158821

Patterson, C.S., 1995, The Cost of Capital: Theory and Estimation, Greenwood Publishing, ISBN 0899308627

Pratt, S.P., Reilley, R.F., Schweihs, R.P., 2000, Valuing a Business: The Analysis of Closely Held Companies, 4th Edition, McGraw Hill Professional, ISBN 0071356150

Rosenberg, B., 1981, The Capital Asset Pricing Model and the Market Model, Journal of Portfolio Management

Simaan, Y., Lee, C.F., 1992, Alternate Approach to Unify CAPM and APT, Review of Quantitative Finance and Accounting, Vol. 2, No. 4

Singh, R., January-March 2008, CAPM vs. APT with Macro Economic Variables: Evidence from the Indian Stock Market, Asia-Pacific Business Review

Stickney, C.P., Weil, R.L., Schipper, K., 2009, Financial Accounting: An Introduction to Concepts, Methods and uses, 13th edition, Cengage Learning, ISBN 0324651147

Montier, J., 2007, Behavioral Investing: A Practitioners' Guide to Applying Behavioral Finance, John Wiley and Sons, ISBN 0470516704

2005, CAPM and APT, Lakehead University, http://flash.lakeheadu.ca/~pgreg/assignments/3019chapter6_w05n.pdf last accessed on November 27, 2009

2005, Capital Asset Pricing Model, Spiritus Temporis, http://www.spiritus-temporis.com/capital-asset-pricing-model/assumptions-and-shortcomings-of-capm.html last accessed on November 27, 2009

2008, CAPM: Theory, Advantages and Disadvantages, ACCA Trainer, http://www.accatrainer.com/upload/1804754796.pdf last accessed on November 27, 2009

2009, Arbitrage Pricing Theory, Answers, http://www.answers.com/topic/arbitrage-pricing-theory last accessed on November 27, 2009

2009, Arbitrage Pricing Theory, Money Terms, http://moneyterms.co.uk/apt / last accessed on November 27, 2009

2009, Associated British Foods, Digital Look, http://www.digitallook.com/cgi-bin/dlmedia/security.cgi?csi=10002&ac=&username= last accessed on November 27, 2009

2009, Investopedia, http://www.investopedia.com last accessed on November 26, 2009

2009, Longman Dictionary of Contemporary English, the Online Version, http://www.ldoceonline.com last accessed on November 26, 2009

CAPM, Lundquist College of Business, http://odin.lcb.uoregon.edu/rcg/teaching/380/3-CAPM.pdf last accessed on November 27, 2009

The APT, U-M Personal World Wide Web Server, http://www-personal.umich.edu/~shumway/courses.dir/ba855.dir/apt.PDF last accessed on November 27, 2009

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