Financial Analysis and Investment

Section 1: Alternative Asset Pricing Models

1.0.        Introduction

Shareholders prefer risk-based pricing models, especially if they are pursuing a mean-variance portfolio analysis (Pástor and Stambaugh, 2000). When there is a linear blend of exposures to the constant risk factors, then the risky part of the mean-variance portfolio will entail the constant benchmark portfolios that copy those sources of risk. While applying this principle, shareholders face various issues, which might be solved by the alternative pricing models. In risk-based models, asset characteristics that are not related to the risk exposures are categorised under the expected returns because of behavioural occurrences such as failure to determine benchmark portfolios as well as overreaction (Pástor and Stambaugh, 2000). Furthermore, shareholders encounter constraints on short sales and borrowing to a certain level.

This report provides a critical discussion of the alternative asset pricing models: the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). It will also provide a synthesis of the cons and pros of each model based on the underlying theories and relevant literature. CAPM marks the birth of asset-pricing theory and provides a powerful means to predict risk measures and the relationship between market risk beta and the expected portfolio return (Fama and French, 2003; Khudoykulov, 2020). On the other hand, APT frameworks clarify the expected hypothetical rate of return of a portfolio in equilibrium as a linear function of the risk of the portfolio, especially in regards to the factors that capture the systematic risk (Celik, 2012). In other words, according to Wei (1988), CAPM emphasizes the covariance between the endogenous market portfolio and asset returns while APT stresses the significance of the covariance between the exogenous risk and asset returns.