Various mathematical models have been developed in order to determine the true value of financial assets. Two of these models, the Capital Asset Pricing Theory and the Arbitrage Pricing Theory, have emerged as two of the most widely accepted methods by which returns may be determined and valuation models developed from these returns (Malevergene & Sornette, 2007). However, as much as they have had loyal followers, there have also been criticisms forwarded by researchers on the validity of these models (MacKinlay, 1995). The models and the criticisms about them shall will be examined in this study.
The models are based on the theory that the basis for choosing assets for investments relies on whether or not they interact with one another, whether they balance each other’s risks, instead of looking at their individual performance when taken individually or in isolation (Scott, 2003). The portfolio theory provides the basis of the CAPM and the APT, and it states that an optimal portfolio is the combination of assets that provides the investor the highest return for the least possible risk level for a specified return (Constantinides & Malliaris, 1995).
The Arbitrage Pricing Theory and the Capital Asset Pricing Model do not owe its existence to a single person or a single effort, but was developed over the years by researchers’ independent inquiry. In the late 40s, Harry Markowitz, a graduate student in economics with a penchant for mathematical processes, was developing his dissertation on the stock market. Originally, he was fashioning his paper after the present value model of John Burr Williams. Halfway through, however, Markowitz realized that Williams failed to account for the impact of risk in his model. His insight into this vital role played by risk analysis in the valuation of portfolio assets led to Markowitz’s now famous