ASSET PRICING MODELS

CAPM AND APT

 BACKGROUND
• If investors behave rationally as suggested by Markowitz
and capital markets are efficient then the returns offered
by individual assets must follow some rule that must fully
and truly reflect the investors’ choice and state of the
capital markets.
• Besides the pricing of the assets must be commensurate
with the risk it entails.
• Since risk has bearing on pricing of assets would pricing
differ under two circumstances –
– when considered alone or
– when considered as part of a portfolio?

RAJIV SRIVASTAVA 2
 ROLE OF VARIANCE AND COVARIANCE
• Risk of an individual asset is measured by standard
deviation.
• But when the asset is part of a portfolio the variance
(standard deviation) of the asset becomes rather
insignificant part of portfolio risk.
• Covariance rather that variance dominates the portfolio
risk.

RAJIV SRIVASTAVA 3
 RISK REDUCTION
• An important implication for portfolio construction is that the
emphasis on the behaviour of returns of a security with respect
to the returns of other securities in the portfolio, rather than on
the variance or standard deviation of its own returns, σ.
• The mathematical model of Harry Markowitz quantifies the
amount of risk reduction.
• Investment in a single security carries the return and risk
associated with particular firm. With addition of other securities
the chances are poor returns of any security may get
compensated by excess returns of other securities.
• Larger the number of securities better would be the offsetting of
poor returns of some of the securities.
RAJIV SRIVASTAVA 4
 SOURCES OF RISK AND CLASSIFICATION
• As we keep adding securities to the portfolio the chances
of achieving better compensating effect improve, and
portfolio returns become more and more stable.
• Therefore diversification helps eliminate the firm specific
risks.
• We need to understand the sources of risk in greater
detail. The variability of returns can arise from two sources.
– Factors specific to a firm
– Factors common to all firms (market)

RAJIV SRIVASTAVA 5
 SYSTEMATIC AND UNSYSTEMATIC RISK
• Factors specific to a firm such as level of earnings, nature of
business, the prospects, quality of management, quality of
products, technology adopted, riskiness of the cash flows, capital
expenditure, growth prospects, etc. affect the returns of a security.
These factors are unique to the firm and any change in returns due
to these factor is referred as unique risk or unsystematic risk.
• Factors common to all firms (market) such as economic growth,
industry growth, government expenditures, levels of taxes, political
environment, weather conditions, international issues, budget
deficit, balance of payment, threats of war, internal strife,
sentiments of the market etc. also affect returns. Since these
factors are market wide the risk emanating from these factors is
referred as market risk or systematic risk.
RAJIV SRIVASTAVA 6
 SYSTEMATIC, UNSYSTEMATIC
AND TOTAL RISK

Total Risk:
Variability of returns due to all
factors

Systematic Risk: Unsystematic Risk:

Variability of returns due to Variability of returns due to
broad, uncontrollable factors firm-specific factors

RAJIV SRIVASTAVA 7
 DIVERSIFIABLE AND
NON-DIVERSIFIABLE RISK
• As we increase the size of the portfolio, called
diversification, the compensating effect would be better.
The risk is diversified
• Therefore unique risk is also referred as diversifiable risk.
• However, the same cannot be said about the market
specific factors.
• The direction of change in the returns of securities due to
market wide factors is more likely to be same. It cannot be
diversified away. Market risk therefore is also called non-
diversifiable risk.

RAJIV SRIVASTAVA 8
 PORTFOLIO RISK
• As we add securities to the portfolio the unique risk starts
diminishing.
• However, the reduction in risk is smaller and smaller as we
add securities to the portfolio.
• After a certain level the reduction in risk is negligible no
matter how large the portfolio becomes.
• There remains a residual risk which cannot be diversified
away. This residual risk is termed systematic risk.

RAJIV SRIVASTAVA 9
 DIVERSIFICATION AND PORTFOLIO RISK
Diversification and Portfolio Risk

Total Risk
Portfolio
Risk, σp

Risk

Market Risk

Number of Securities, n

RAJIV SRIVASTAVA 10
 MEANING OF COVARIANCE
• To what extent diversification can reduce risk?
– It has been observed that risk reduction after 15-20 securities in the
portfolio is nominal and perhaps not worth incurring the cost of
identifying the more securities.

• If there is a lower bound to the risk how big or small the

portfolio size should be?
– The lower bound to the risk is called systematic risk and all diversified
portfolio would have to carry it. The extent of diversification beyond
a point does not matter.

• How do we include or exclude securities from the

portfolio?
– Markowitz model provide important clue to selection of securities
with negative correlation for inclusion in the portfolio.
RAJIV SRIVASTAVA 11
 ASSET PRICES AND RISK
• With bifurcation of risk into systematic and unsystematic, a
natural question that arises is which of the two, or the
aggregate of the two would determine returns.
• In an efficient market should an investor get rewarded for
carrying unsystematic risk when it is easily diversifiable?
– The overwhelming opinion is that unsystematic risk should not be
rewarded in efficient markets. The risk about which investor cannot
do anything should only get rewarded in an efficient capital market.

• Capital asset pricing model (CAPM) establishes the formal

relationship between risk and return.
• It answers the question that what returns are appropriate
when all investors diversify the Markowitz way.
RAJIV SRIVASTAVA 12
 ASSUMPTIONS
CAPITAL ASSET PRICING MODEL (CAPM)
• The assumptions of CAPM are:
– Only the expected return and the risk form the basis of decisions.
– All investors have homogeneous expectations.
– All investors are rational in their decision-making.
– All investors have identical holding periods.

• The conditions of perfect capital markets prevail such as

– Free and instantaneous flow of information.
– No transaction cost.
– No investor is large enough to influence the price.
– No taxes or uniform taxes.
– The investor can lend and borrow at the same rate of risk free rate.

RAJIV SRIVASTAVA 13
 CAPITAL MARKET LINE (CML)
• Portfolio theory: Concluded that all investors would choose
optimal portfolio, O along with risk free asset, F and
allocate funds between the two to achieve desired
investment objectives.
– This optimal portfolio O is renamed as market portfolio, M in an
efficient market with it return as RM risk as σM.
– This portfolio shall be on efficient frontier and will also be on
maximum slope line from F.
– With the introduction of risk free asset the curved efficient frontier
gets converted into a straight line.

RAJIV SRIVASTAVA 14
 COEFFICIENT OF CORRELATION
• With the risk free asset, F one may draw a capital
allocation line through risk free asset, F and market
portfolio, M on the efficient frontier.
• This line, FMX is called capital market line and is a
relationship between risk free asset and efficient asset.
• The slope of CML would indicate reward for taking market
risk and is given by

RM − RF
Slope of CML =
σM

RAJIV SRIVASTAVA 15
 CAPITAL MARKET LINE – GRAPHICAL VIEW

RAJIV SRIVASTAVA 16
 SEPARATION THEOREM
– Investment choices are made with two interrelated decisions:
1. which of the securities to invest in, called investment decision, and
2. how much to invest in each securities, called financing decision.

• The first decision i.e. investment decision, is already made for

all investors. It implies that all investors must hold the two
assets, F and M.
• The next decision i.e. financing decision would vary from
investor to investor. How much to lend or borrow is governed
by the trade-off between desired return or the risk appetite of
investor.

RAJIV SRIVASTAVA 17
 RISK PREMIUM ON MARKET PORTFOLIO
• Proceeding with the assumptions of lending and borrowing at
risk free rate and the risk averse nature of the investor we
attempt to find what should be the risk premium on the
market portfolio. We know that all investors have utility
function
U = Rp - .005 Aσp2
Where Rp = f RM+ (1 - f) RF and σp = f σM

• With investor seeking maximisation of utility we put dU/df = 0,

with f the proportion of wealth in the risky asset as the
variable. It would give the optimum proportion of investment
in the risky portfolio, f
= (RM - RF)/.01AσM2

RAJIV SRIVASTAVA 18
 PROFILE - PORTFOLIO RISK AND RETURN
• All investors possess only two assets F and M in varying
proportions. Some borrow and some lend depending
upon the desired risk-return profile.
• If so, then on aggregate basis borrowing and lending
should cancel out each other.
• The borrowing and lending would be equal. Therefore on
an aggregate basis fM = 1 and for market as a whole
the risk premium, RM – RF = .01AσM2
Or Market Risk Premium  σM2

RAJIV SRIVASTAVA 19
 PORTFOLIO RISK OF AN ASSET
• As per Markowitz diversification the portfolio risk is sum of
all variance and covariance of all the assets consisting the
portfolio.
• Contribution of a Security S to the portfolio risk is
dominated by its covariance with other securities in the
portfolio, and not as much by its own variance.
• Further the risk of the portfolio is also dependent upon the
proportions of investment in the respective securities.
– The total risk of the portfolio consisting of n securities is the following
covariance matrix, which is dependent upon the fractions of
investment placed in each security, fn besides the covariance of the
two securities, Cov (n,m).
RAJIV SRIVASTAVA 20
 CASE 1: PERFECT POSITIVE CORRELATION
• The contribution of one security, S to the portfolio risk is
proportional to the amount of money invested in security S and
its weighted covariance with other securities in the portfolio is
given by
fs{f1Cov(s,1)+f2Cov(s,2)…..+fsCov(s,s) .....+fnCov(s,n)}= fs Cov (s,m)

RAJIV SRIVASTAVA 21
 CAPITAL ASSET PRICING MODEL
• All investors hold the risk free asset, F and the risky market portfolio, M.
Suppose we find a security, S that offers better returns than M with expected
return of Rs and standard deviation of σs. If so, the investor would borrow
some money to invest in newly found attractive opportunity, S.
• Investor A invests in market portfolio while B invests in security S. :

Investor A: Borrows Δ and invests in market portfolio

• Extra returns and risk due to change in the portfolio would be = Δ(RM – RF)
• New variance = (1+Δ)2 σM2  (1+2Δ) σM2(Ignoring Δ2 being too small.
• Incremental Risk  2ΔσM2
• Incremental Risk Premium  Δ(RM – RF)/2ΔσM2

RAJIV SRIVASTAVA 22
 PORTFOLIO RETURN AND RISK PROFILE
Investor B: Borrows Δ and invests in security S
• Similar to the investor A, the investor B opting for incremental borrowing
invested in the newly found security S would also face some extra returns
and risk due to change in the portfolio.
• Increase in Return = Δ(Rs – RF)
• The new risk = σM2+Δ2σS2+2ΔCov (S, M)
• Increase in risk is  2ΔCov (S, M)
• Incremental risk premium  Δ(RS- RF)/2Δ Cov (S, M)

RAJIV SRIVASTAVA 23
 CAPM FINAL EQUATION
• For equilibrium in the prices the incremental risk premium for
investor A and investor B must be identical. We equate the two
to get what is known as Capital Asset Pricing Model.
Δ(RS - RF ) Δ(RM - RF )
=
2Δ Cov(S, M) 2Δ M 2
Cov (S, M)
RS = RF + 2 (RM - RF )
σM
= RF + β(RM - RF )
Cov (S, M)
because β = 2 by definition
σM
RAJIV SRIVASTAVA 24
 INTERPRETING CAPM
Reward for waiting and reward for risk
• Security returns would be equal to the reward for waiting plus
the reward for the risk assumed. The risk assumed by the investor
is given by β of the security and reward bust be must be
proportional.
Returns of the security, RS = Reward for waiting + Reward for risk
= RF + β x (RM – RF)
Quantifying reward for risk
• The risk premium of security (RS –RF) is proportion to the risk of the
security as measured by its beta multiplied by risk premium of
the market portfolio (RM – RF).
RAJIV SRIVASTAVA 25
 BETA AND SIGMA
• Under Markowitz model of diversification we attempted to
quantify the risk by standard deviation which measures total risk.
In CAPM we bifurcated risk into two elements - the systematic
risk and the unsystematic risk. According to CAPM reward is
proportional to risk as measured by beta.
• Beta is defined as ratio of variance of the asset returns and
covariance of market returns. Beta is a relative measure of risk.
• Investors do not get rewarded for unsystematic risk simply
because it is diversifiable. The only concern addressed by CAPM
is the systematic risk, which becomes relevant for determination
of pricing of the financial asset.

RAJIV SRIVASTAVA 26
 BENCHMARK VALUES
• For estimating returns of any security we need three inputs –
– risk free rate of return,
– market returns, and
– relative measure of risk, beta.

• Following are considered reasonable proxies

• Risk free rate of return, RF The yield on T-Bills (ST Govt.
Security) is assumed as risk free. Assumed to have beta of zero.
The yields on the T-Bills would therefore replace the risk free rate.

• Market returns, RM The market portfolio is assumed to have

β = 1 and market returns are taken as benchmark for RM.
RAJIV SRIVASTAVA 27
 INTERPRETING BETA
• Beta is measured in terms of their relationship with the chosen
market index.
Covariance of stock returns with market returns Cov( S ,M )
Beta of Stock = =
Variance of market returns  M2
• Beta indicates the sensitivity of the security returns with respect
to market
– If beta > 1 security returns are more sensitive than market
– If beta < 1 security returns are less sensitive than market
– If beta = 1 the sensitivity of returns of security is same as the of the market.

RAJIV SRIVASTAVA 28
 MEASURING BETA
• As a proxy to the market any broad based index can be
used. We need to obtain a relationship of stock returns with
respect to market. This can be done through regression of
stock returns and market returns
y =  + x + e
n∑ XY - ∑ X ∑Y ( X * Y n) - X * Y .
Beta,  = =
n∑ X - (∑ X )
2
2
(X 2 n) - X 2
Average of Products - Product of Averages
=
Average of Square(Market) - Square of Average(Market)
Alpha, α = Y - βX
Where y = Returns on the stock, x = Returns on the index, and
X and Y are the average market returns and stock returns respectively

RAJIV SRIVASTAVA 29
 BETA THROUGH REGRESSION
Figure 6-4: Finding Beta of Stock
6.00
y = 1.3287x + 0.0855
R² = 0.4318
4.00
Regression Line

2.00
Marutu Returns, %

0.00
-3.00 -2.00 -1.00 0.00 1.00 2.00 3.00

-2.00

-4.00

-6.00

-8.00
Nifty Returns, %

RAJIV SRIVASTAVA 30
 CAPM AND PORTFOLIO
• CAPM has implications for portfolio selection, management
and performance measurement
• Portfolio Design
– Investors must only be concerned with the risk that cannot be diversified
away.
– Another implication of CAPM is that passive investment is efficient as all
choose market portfolio and risk free asset. Only the proportions of
investment is them varies from individual to individual.
• Portfolio Revision
– For portfolio balancing CAPM suggests a strategy of adjusting beta
according to the market sentiments. In rising market the portfolio
manager can shift the portfolio in favour of high beta stocks while in
falling markets the orientation may change to having low beta stocks.
RAJIV SRIVASTAVA 31
 PORTFOLIO BETA
• Portfolio Beta If many securities are combined to
form a portfolio with fi as proportion of the investment in
security i, the portfolio’s return and risk are also given by
CAPM. In terms of regression equation described earlier
portfolio returns can be represented as
n n
Rp = ∑ fi x Ri = ∑ fi x (αi +  i Rm + ei )
1 1
n n n
Rp = Ri = ∑ fi x αi + RM  fi x β i +  fi iei
1 1 1
n
Beta of the portfolio, βP =  fi x βI
1
RAJIV SRIVASTAVA 32
 TOTAL RISK, UNSYSTEMATIC RISK AND
SYSTEMATIC RISK
• CAPM bifurcates risk of the security to its two components;
the systematic risk and the unsystematic risk.
• The variance of the returns of the security can be obtained
by taking variance of the regression equation.

Var(Ri ) = Var(αi + βi RM + ei )
σi 2 = Var(αa+ βi 2Var(RM ) + Var(ei ); Var( ) being zero, we get
= βi 2σM 2 + σie 2 ;
Total Risk = Systematic Risk + Unsystematic Risk

RAJIV SRIVASTAVA 33
 LIMITATIONS OF CAPM
• Single Index Model The most serious objection to CAPM is
that it consolidates all risk in a single factor called beta. To
many analysts and researchers, stocks do react to variety of
factors and it is too simplistic to assume that returns would be
governed by single factor.
• Single Period Model CAPM applies as single period
model where returns and risk are considered for one
investment horizon which is assumed identical for all
investors.

RAJIV SRIVASTAVA 34
 LIMITATIONS OF CAPM
• Homogeneous Expectations If the expectations of
investors were different the diversity of expectations would
lead to somewhat different SMLs.
• Identical Lending and Borrowing Rates Another assumption
that is objected is regarding the unlimited lending and
borrowing at the same risk free rate.
• Ignores Transaction Cost
• Constancy of Beta
• Incomplete and Expanding Universe of Assets
• Benchmark Errors
RAJIV SRIVASTAVA 35
 SHARPE’s SINGLE INDEX MODEL
• William Sharpe and others have attempted a simplified model of Harry
Markowitz of finding an optimum which has substantially reduced data
requirements and consequent lesser computations.
• Markowitz model uses correlation of securities with one another and their
covariance for determining the portfolio risk and arriving at optimum
combination.
• Sharpe model for optimisation of portfolio, instead assumes that two
assets influence each other only through a broader parameters that can
be gauged from their relationship with the market index.
• Therefore instead of estimating the covariance of each asset with all
others it is prudent to use this relationship with a common asset i.e. market
index. The relationship of the asset with the index can be said to be an
aggregate of its covariance with all remaining securities in the portfolio.

RAJIV SRIVASTAVA 36
 COVARIANCE AND BETA
• The relationship of two assets is given by covariance of two as
below: for two assets i and j.
Cov(Ri,Rj) = ∑(Ri - Ri )(R j - R j )
• Multiplying and dividing by the market, M variance we get
or Cov(Ri ,R j ) = ∑(Ri - Ri )(R j - R j )
(M - M )(M - M )
 m2
Cov(Ri ,M)Cov(R j ,M) 2 Cov(Ri ,M)
Cov(Ri ,R j ) = 2 = β β σ
i j m Since βi = 2 by definition
σm σm

Cov( Ri ,Rj ) =  i  j m 2

RAJIV SRIVASTAVA 37
 ARBITRAGE PRICING THEORY

RAJIV SRIVASTAVA 38
 ARBITRAGE PRICING THEORY
• One of the limitations of CAPM was that it consolidated all
risks in a single parameter called beta, Is it adequate to
capture all risks in single factor?
• While consolidating all the environmental risk in a single
measure i.e. market and capturing the sensitivity of returns
in the beta we assumed that all securities respond to
changes in the macro-economic environment in similar
fashion.
• Arbitrage Pricing Theory (APT) emphasised the need to
have multi-factor model to explain behaviour of the price
of the security.

RAJIV SRIVASTAVA 39
 ARBITRAGE PRICING THEORY
• APT recognises and assumes:
– returns of the security respond differently to different economic
factors and having varying sensitivities to such economic factors.
– response of different individual securities is different for the same
economic factor.
– It neither assumes normal distribution, nor the quadratic utility function.
– It assumes efficient markets and investors’ preference for more
wealth.
– returns of each security depends upon its sensitivities to the
unanticipated changes in various economic factors.
– expected return a function of multiple systematic factors rather than
single factor captured by market as a whole represented by index.

RAJIV SRIVASTAVA 40
 ARBITRAGE PRICING THEORY
• The general APT model as formulated by Roll and Ross is
given as:
• Expected Returns for a security,
R = λ0 + β1 λ1 + β2 λ2 + β3 λ3 + β4 λ4 + Noise (e)
• Like CAPM the APT also states that each stock’s return
depends linearly on macroeconomic factors and partly on
noise (events unique to the firm).

RAJIV SRIVASTAVA 41
 HOW APT WORKS
• The process of pricing of asset under APT is to find an
equilibrium relationship among all factors that influence
returns based on arbitrage process.
• If there is any inequilibrium the arbitrages process sets in to
buy the undervalued and sell the overvalued so as to
restore the equilibrium of returns.
• Assume that returns of the security with single factor APT is
governed by following equation:
APT Returns R = λ0 + β1 λ1

RAJIV SRIVASTAVA 42
 HOW APT WORKS
• The basic premise of arbitrage pricing theory is that if two
portfolios are constructed and have dependence only on
one factor, then the process of arbitrage will derive the
price of the portfolios to converge.
• Assuming the values of the λ0, λ1 as 2% and 10%
respectively, then APT implies that with 1% change in
estimate of GDP growth rate (factor 1) will cause returns to
change by 10%.
APT Equation would be: 2 + 10 λ1
• With no unanticipated change in the GDP growth the
returns on the security would be 2%.
RAJIV SRIVASTAVA 43
Standard Deviation, σ = Variance = 50.19 = 7.08%

HOW APT WORKS

• Process of Arbitrage We may define arbitrage as a
process in which no investment is made and no risk is
assumed and yet make profit. The arbitrage can be set up
as follows:
– Making no net investment initially For making no
investment any security bought must be funded by short selling of
another security to generate amount required to buy the security.
– Elimination of risk The portfolio of long and short
securities must done in such a manner that portfolio beta becomes
zero.
– Derive profit by unwinding positions At the end of
investment horizon that must coincide with the time required for
mispricing to correct the investor unwinds the initial positions, hoping
that assets are now priced correctly with respect to that risk factor.
RAJIV SRIVASTAVA 44
Standard Deviation, σ = Variance = 50.19 = 7.08%

HOW APT WORKS – AN ILLUSTRATION

Two portfolios A and B are correctly priced, with following data:
Current Market Expected price
Portfolio Return, % Beta APT
Price after 1 year
A 20 1.2 200 240 20 = λ0 + 1.2λ1
B 30 2.0 50 65 30 = λ0 + 2.0λ1
This gives λ0 = 5 and λ1= 12.5 and APT Equation as 5 + 12.5 β

Another portfolio C has beta = 1.40.

Therefore its APT returns are 5 + 1.4 x 12.5 = 22.50%.
It has current market price of Rs 400 with expected price of after one year
as Rs 480 offering an estimated return of 20% instead of APT returns of
22.5%.
Therefore it is OVERPRICED, and must be sold now only to be bought later
after one year when the pricing is corrected.
RAJIV SRIVASTAVA 45
Standard Deviation, σ = Variance = 50.19 = 7.08%

HOW APT WORKS – AN ILLUSTRATION

– Making no net investment initially For making no
investment any security bought must be funded by short selling of
another security to generate amount required to buy the security.
Therefore WA + WB + WC = 0; - WC = (WA + WB) = - 0.50
– Elimination of risk The portfolio of long and short
securities must done in such a manner that portfolio beta becomes
zero.
1.20 WA + 2.0 WB + 1.4 WC = 0
This gives WA = 1/8, WB = 3/8 and WC = -4/8 = -1/2
– Derive profit by unwinding positions At the end of
investment horizon that must coincide with the time required for
mispricing to correct the investor unwinds the initial positions, hoping
that assets are now priced correctly with respect to that risk factor.

RAJIV SRIVASTAVA 46
Standard Deviation, σ = Variance = 50.19 = 7.08%

HOW APT WORKS – AN ILLUSTRATION

– Making no net investment initially
Therefore WA + WB + WC = 0; - WC = (WA + WB) = - 0.50
– Elimination of risk 1.20 WA + 2.0 WB + 1.4 WC = 0
This gives WA = 1/8, WB = 3/8 and WC = -4/8 = -1/2
– Derive profit by unwinding positions Initial position and
unwinding after one year would be as follows:
INITIAL POSITION, T = 0 UNWINDING INITIAL POSITION, T = 1
Portfolio Action Cash Flow Action Expected price Cash Flow
C - 1.0 share + 400 Buy 1.0 share 480 - 480
A + 1.5 shares - 300 Sell 1.5 shares 240 + 360
B + 2.0 shares - 100 Sell 2.0 shares 65 + 130
Net Investment 0 Arbitrage Profit +10
RAJIV SRIVASTAVA 47
 APT AND CAPM
APT as compared to CAPM makes fewer assumptions.
• CAPM stipulates market portfolio as a prerequisite and is
an asset that is mean variance efficient. APT does not
require market portfolio for pricing of the assets. The
condition of mean variance efficiency is irrelevant for APT.
• APT is multifactor model and CAPM is single factor model.
• APT dispenses with investors’ utility function. It assumes
that investors prefer more wealth to less wealth.
• The assumption for returns to have normal distribution is
also not required by the APT.

RAJIV SRIVASTAVA 48
 APT AND CAPM
• No assumptions related to lending and borrowing at risk
free rate is made under APT.
• Since APT is based on identifying arbitrage opportunities it
is not necessary for markets to be efficient. Few large
investors are enough to correct the pricing of assets
through arbitrage.

RAJIV SRIVASTAVA 49
 APT AND CAPM – COMMON ASSUMPTIONS
• The assumptions that are common to both APT and CAPM
are that
1. investors prefer more wealth to less wealth,
2. investors are risk averse
3. all investors have homogeneous expectations and
4. conditions of perfect capital market exists.
APT is that the short selling is allowed that permits set up of
arbitrage opportunity.

RAJIV SRIVASTAVA 50
 LIMITATIONS OF APT
• The construction of APT model is open-ended as it leaves
the selection of price determinant factors and sensitivities
of returns purely at the discretion of investor.
• The sensitivities of returns, the beta factors (in CAPM
parlance) are difficult to determine due to inadequacy of
data with respect to each economic variable.
• Being open-ended leads to controversies and conflicts
among theorists that don’t let the model become popular
• However, it is acceptable because it is the divergence of
ideas that makes markets efficient rather than
convergence of ideas.
RAJIV SRIVASTAVA 51
 LIMITATIONS OF APT
• Flexibility of APT may be seen as advantage or
disadvantage depending upon the orientation of
investors.
• It can neither be said to be inferior or superior to CAPM. At
best it must be regarded as an alternative to CAPM in
pricing of assets.

RAJIV SRIVASTAVA 52