Capm vs. Apt: an Empirical Analysis

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Yurop Shrestha Economics Thesis CAPM vs. APT: An Empirical Analysis Introduction The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners. It is used to estimate cost of capital for firms, evaluating the performance of managed portfolios and also to determine asset prices. Since the inception of this model there have been numerous researches and empirical testing to assess the strength and the validity of the model.…show more content…
The three most commonly used techniques are the “market model” (This is the most common one. I will be using this for my testing), Scholes-Williams, and Dimson estimators. There are numerous advantages/benefits as well as some flaws in all the beta estimating techniques. Examining that fall outside the field of this paper but the limitation section looks at the problems of the different techniques very briefly. In order to compare the two models, staying consistent with the estimation techniques will be sufficient regardless of their flaws or biases. ARBITRAGE PRICING THEORY The APT is the alternative model for asset pricing first developed by Ross (1976). This is a very appropriate model as it agrees perfectly with what appears to be the intuition behind the CAPM. It is based on a linear return generating process as a first principle. Also it is more sophisticated that the CAPM because it takes into account more systematic factors that might be relevant. It examines other macroeconomic variables besides the market risk, making this model more sophisticated. It captures other factors that might have been ignored by the CAPM. Formally the APT can be stated as follows. rj=Erj+bj1F1+ bj2F2+…+bjnFn+ϵj (3) Where, E(rj) is the jth asset’s expected return, Fk is a systematic factor (assumed to have mean zero), bjk is the sensitivity of the jth asset to factor k, also called factor loading, and εj is the

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