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Introduction Managing portfolio and investing in stocks is very risky and could be tricky, as a result, financial experts and

investors view it as necessary or smart to know what to expect when they invest. Due to this, different statistical models have emerged to attempt to scientifically measure the potential returns on an investment. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two of such models. The purpose of this essay is to critically compare the Arbitrage Pricing Theory with the Capital Asset Pricing Model as used by fund managers in the United Kingdom. Captial Asset Pricing Model (CAPM) When Sharpe (1964) and Lintner (1965) proposed the Capital Asset Pricing Model (CAPM), it was seen as a leading tool in measuring if an investment will yield in positive or negative returns. It attempts to explain the relationship between investment risk and expected reward of risky securities (Ushad, 2011; Reilly and Brown, 2011; Heshmat, 2012). The CAPM helps to determine the required rate of return for any risky asset (Reilly and Brown, 2011). The CAPM states that the expected return on a security or a portfolio equals the rate on a risk-free security plus a risk premium (Heshmat, 2012: 504). It indicates that the expected return on an asset has a positive linear relationship with the non-diversifiable risk of the security (beta) (Heshmat, 2012). Ushad (2011) explains that the CAPM is based on the premise that higher returns should be associated with higher beta risks. It

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a)

Managing portfolio and investing in stocks is very risky and could be tricky, as a result, financial experts and investors view it as necessary or smart to know what to expect when they invest. Due to this, different statistical models have emerged to attempt to scientifically measure the potential returns on an investment. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are two of such models. The purpose of this essay is to critically compare the Arbitrage Pricing Theory with the Capital Asset Pricing Model as used by fund managers in the United Kingdom.

Captial Asset Pricing Model (CAPM) b) When Sharpe (1964) and Lintner (1965) proposed the Capital Asset Pricing Model (CAPM), it was seen as a leading tool in measuring if an investment will yi eld in positive or nega ive returns It ttempts to explain the relationship between investment risk and expected reward of risky securities (Ushad, 2011; Reilly and Brown, 2011; Heshmat, 2012). The CAPM helps to determine the required rate of return for any risky asset (Reilly and Brown, 2011). The CAPM stat s that the expected return on a security or a portfolio equals the rate on a risk-free security pls a risk premium (Heshmat, 2012: 504). It indicates that the expected return on an asset has a positive linear relationship with the non-diversifiable risk of the security (beta) (Heshmat, 2012). Ushad (2011) explains that the CAPM is based on the

premise that higher returns should be associated with higher beta risks. It 3i3s3 3u3s3u3a3l3l3y3 3c3a3l3c3u3l3a3t3e3d3 3a3s3 3f3o3l3l3o3w3s3:3 3E3(3R3i3)3=3 3R3f3 3+3 3i3 3(3E3(3R3m3)3 3-3 3R3f3)3.3 3(3U3s3h3a3d3,3 323031313)3.3 3W3h3e3r3e3,3 3E3(3R3i3)3 3=3 3r3e3t3u3r3n3 3r3e3q3u3i3r3e3d3 3o3n3 3f3i3n3a3n3c3i3a3l3 3a3s3s3e3t3 3i3 3R3f3 3=3 3r3i3s3k3-3f3r3e3e3 3r3a3t3e3 3o3f3 3r3e3t3u3r3n3 3i3 3=3 3t3h3e3 3s3e3n3s3i3t3i3v3i3t3y3 3o3f3 3t3h3e3 3a3s3s3e3t3 s3 3r3e3t3u3r3n3 3t3o3 3t3h3e3 3m3a3r3k3e3t3 3E3(3R3m3)3 3=3 3a3v3e3r3a3g3e3 3r3e3t3u3r3n3 3o3n3 3t3h3e3 3c3a3p3i3t3a3l3 3market Sharpe (1964) and Lintner (1965) proposed various assumptions that the CAPM must take into consideration. According to Watson and Head (2007), Reilly and Brown (2011), these assumptions include: Investors can lend or borrow at a risk free rate All unsystematic, that is non-market, risks are eliminated A standardised holding period is assumed by the CAPM in order to make comparable the returns on different securities. Thus a single-period transaction horizon Transaction costs and taxes are excluded All investors have equal access to all securities The CAPM has often been criticised as being very unrealistic because it assumes that investment is made in an ideal world. However, Watson and Head (2007) stress that in real world situations, investment decisions are made by individuals and companies. Another criticism is that in real world situations, investors cannot lend or borrow at a risk free rate. This is because individual investor risk is usually higher that that of the government (Watson and Head, 2007). They also argue that though CAPM assumes that investment take place over single-period time horizon, experience indicates that in the re(1990) analysed UK private sector data, it was found out that the CAPM may not be applicable in the UK. Though CAPM suggests a positive linear relationship with rates of return and systematic risks, there is evidence that which indicates that additional risk variables n011). Thus Ramadan (2012) stresses that another model like the Arbitrage Pricing Theory (APT) which reflects a linear multi-factor relationship in addition to systematic risk and other macroeconomic factors needs to be considered.

Arbitrage Pricing Theory (APT) The Arbitrage Pricing Theory as proposed by Ross (1976) is still one of the most influential capital market theories. It is reasonably intuitive, requires limited assumptions and allows (Reilly and Brown, 2011). Dhankar and Singh (2005) suggests that the APT offers an alternative explanation to the risk and return of an investment. The APT proposes that pricing of risky assets relies on only the set of variables whose influence felt m ost by all risky assets together (Otuteye, 1998). This theory is very attractive because strong results can be achieved from relatively weak assumptions (Reisman, 1988), Reilly and Brown (2011) highlights three major assumptions of the APT Capital markets are perfectly competitive Investors will always prefer more wealth to less wealth with certainty The stochastic process generating asset function of a set of K risk factors. The APT is usually calculated as follows: Ri= E(Ri)+ bi1(i + bi2(i +....+bik(k + (i for i = 1 to n Where Ri = the actual return on asset i during a specified time period, i = 1, 2, 3, . . . n E(Ri) = the expected return for asset i if all the risk factors have zero changes bij = the reaction in asset is returns to movements in a common risk factor j (k = a set of common factors or indexes with a zero mean that influences the returns on all assets (i = a unique effect on asset is return (i.e., a random error term that, by assumption, is completely diversifiable in large portfolios and has a mean of zero) n = number of assets Some authors (Bower et al, 1984; Dhankar and Singh, 2005)) have argued that APT is a better choice than the CAPM for evaluating stock returns. Otuteye (1998) highlights key advantages of the APT over the CAPM. He stresses that the APT makes no assumptions about the distribution of security returns. He also points out that though the APT implies that all investors are risk-averse, it does not restrict the utility functions of investors. Contrary to what the CAPM points out, the market