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FINANCIAL MARKET AND PRODUCT RISK - Essay Example
Finance & Accounting
Pages 4 (1004 words)
Critically compare the Arbitrage Pricing Theory (APT) with the Capital Asset Pricing Model (CAPM) for use by a fund manager in the UK Introduction In the arena of modern financial theory, the progress of the financial asset pricing models has been the most significant progress (Satchell, 2007, p.12)…
The two of the stylized financial asset pricing model is Capital Asset Pricing Model (CAPM) and Arbitrage Pricing theory (APT). The paper will be focusing on the critical evaluation of these two asset pricing models and will be analyzing the justification of its use with that of a fund manager in the United Kingdom. Let us begin our discussion with the notion of these two models before plunging into their critical evaluation. Mechanics of CAPM The capital asset pricing model (CAPM) developed by Sharp (1964), Linter (1965) and Mossin (1966) (Zhang & Wihlborg, 2004, p.1) assumes that stock returns are usually evolved from one factor model which represents the market portfolio of all the risky assets. The theory is structured on the notion that it is an aggregation of the Portfolio theory and some additional ones. In the CAPM model, the concept of risk free asset resulted in the derivation of Capital Market Line which is referred to as the new efficient frontier. The equation for the CAPM model can be stated as follows: is the required rate of return on a risky asset and it is a function of risk free rate and risk premium . The market risk premium is the difference between the return on the market and the risk free return. ...
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