It is obvious that the CAPM has gained massive popularity due to its ‘intuitive based approach’ of classifying risks into 2 buckets – ‘a risk free part’ and ‘the risk part that is relative to the market index’. However, this is also its greatest inherent weakness – the oversimplification of risks.
Origins of Arbitrage Pricing Model
In the 1970’s Mr. Stephen Alan Ross, professor and economist, introduced the concept of ‘multiple factors’ that can influence the risk component – motley of ‘macro-economic factors’.
So, the basic idea is to breakdown risks into individual identifiable elements that influence the overall risk in a proportion (called ‘factor’), and each factor gets assigned its own beta; and the sum total of all the assets’ ‘sensitivities’ to ‘n’ factors will give the ‘expected rate of return for the asset’.
In a simplistic way, if a particular asset, say a stock, has its major influencers as the ‘interest rate fluctuations’ and the ‘sectoral growth rate’, then the stocks’ return would be calculated by using the Arbitrage Pricing Theory (APT) in the following manner:
- (a) Calculate the risk premium for both these two risk factors (beta for the risk factor 1 – interest rate, and beta of the risk factor 2 – sector growth rate; and,
- Adding the risk free rate of return.
Thus, the formula for APT is represented as –
Rf+ β1(RP1) + β2(RP2) + ….βj(RPn)
It is thereby clear that APT strives to model E(R) as ‘a linear function of various macro-economic factors’ where sensitivity to changes in each factor is represented by a factor-specific beta coefficient.
Note that the APT by itself doesn’t provide for the macro-economic factors that will be needed to be tested for its sensitivity – however these have to be judicially developed by the financial analysts keeping in mind the economy they are put in.