CAMP and APT Models (Coursework Sample)

Advanced Finance Part I
Question 1 part A
Assessment of CAPM and APT models
Introduction
There are different models that can be used to assessing the returns trade-off and returns of investing in different securities. Assessment of the riskiness of the security to its returns can be done using the capital asset pricing model, or can use the arbitrage pricing model (Connor & Korajczyk, 1986). Thus, the current analysis will focus into this two models in-depth to bring out their similarities and differences.
Similarities between CAMP and APT
CAPM and APT are both models for assessing the theoretical rate of return on assets. They both can also be used when the investment is on a portfolio of assets. Thus we are saying that this models are alternatives to each other in determination of the expected return. The two models are linear in nature, although CAMP uses one factor beta and APT uses multiple factors, both models are linear in form (Connor & Korajczyk, 1986; Fama & French, 2004).
However, as will be shown throughout the essay, they both have significant differences in determining this rate of return.
Differences between CAMP and APT
According to Fama & French (2004) CAMP only looks at sensitivity of an asset to the changes in the market, while APT will looks at a wide range of factors running from macro to industry specific factors. In this assumption for both models, APT can be said to be more encompassing. However, it introduces more uncertainty to determination of the rate since most of this factors are changing and their dynamism are hard to explain.
The Capital Asset Pricing Model (CAPM) is an equilibrium asset pricing theory showing that equilibrium rates of expected return on all risky assets are a function of their covariance with the market portfolio (Fama & French, 2004). The CAPM is a single-index model that defines systematic risk in relation to a broad-based market portfolio (i.e., the market index). This single factor (“beta”) is unchanging:
Rj = Rf + Bj(Rm – Rf)
Where;
Rj = expected return on an asset or portfolio
Rf = risk-free rate of return
Rm = expected return on the market
Bj = volatility of the asset or portfolio to that of the market m.
Arbitrage Pricing Theory (APT) is an equilibrium asset pricing theory derived from a factor model by using diversification and arbitrage. The APT shows that the expected return on any risky asset is a linear combination of various factors (Connor & Korajczyk, 1986). That is, the APT asserts that an asset’s riskiness and, hence, its average long-term return, is directly related to its sensitivities to certain factors. Thus, the APT is a multi-factor model that allows for as many factors as are important in the pricing of assets. However, the model itself does not define these variables. Unlike the CAPM, which recognizes only one unchanging factor, the key factors in APT can change over time.
Rj = Rf + Bj1(RF1 – Rf) + … + Bjk(RFk – Rf)
where
Rj = return on an asset
Rf = risk-free rate of return
Bj = sensitivity of an asset to a particular factor
RFk = expected return on a portfolio with an average (1.0) sensitivity to a factor k
j = an asset
k = a factor
Research suggests that several macroeconomic factors may be significant in explaining expected stock returns (i.e., these factors are systematically priced):
(1) Inflation;
(2) Industrial production;
(3) Risk premia as measured by the spread between low and high grade bonds;
(4) Yield curve, (i.e., slope of the term structure of interest rates.
Other researchers have identified additional factors that may influence an asset’s return.
(5) Real GNP growth;
(6) Rate of growth of real oil prices (i.e., an energy factor);
(7) Real defence spending;
(8) Market index.
Thus from this, we can be able to delve to one of the key difference that exist between the two models. APT model, though good in accommodating other factors which are not accommodated in CAPM, the model is not able to spell out the factors distinctively.
Both models have their origin. CAMP was designed in 1960, while APT was in place in 1975. Thus it can be eluded that APT is an advance of CAMP from one factor to many. With CAMP the level of risk is known, thus APT was brought forth as a linear estimation to be able to accurately assess the market risk (Connor & Korajczyk, 1986).
The CAMP uses the risk free rate. Mainly uses the federal fund rate or 10 year government bond yield. It incorporates the beta of the assets, expect return, and investment risk to be able to convert the asset into an investment (Roll & Ross, 1980; Fama & French, 2004). As for the APT, the model makes use of fewer assumptions. However, this makes its more complex and hard to use. Unlike the CAMP, the model assumes that the volatility is not only caused by the asset and the market of operation, but there are a wide range of factors that contribute to the rate (Fama & French, 2004). The most complex part of using the APT however, is in its inability to spell out specific company and macro factors that are to be used in the model (Connor & Korajczyk, 1986). This forms the major weakness of the model. Most people have used a wide range of different factors, thus it is possible that the commonly used factors are not the right ones, or they have not been exhausted, which could mean that the estimated return is not correct.
Another major difference lies on definition of variable. For instance, while CAMP makes use of expected market return, APT makes use of expected rate of return and the risk premium of other factors (Fama & French, 2004). This will mean that the CAMP model will be having a higher coefficient value on that beta. Consequently, leading to a higher rate compared to APT. Thus we can allude that investors making use of this two models to arrive to a decision may make opposing decisions. Those using CAMP may feel the rate is worth investing in since it is higher as compared to those using APT as it produces a lower return (Roll & Ross, 1980). However, from the analysis it is possible to allege that APT is a more accurate model compared to CAMP, and thus inventors making an investment decision making use of APT may make more realistic and appropriate decisions compared to those using CAMP, since APT has more factors and thus has arrived at a rate looking at different changes in the whole ecosystem.
Strengths and weaknesses of the models
It is important to note that although APT is seen to be more accurate, it is tedious, and requires a lot of time to arrive at the factors to be used and make estimations. Thus it is not appropriate for argent decision making (Roll & Ross, 1980). Therefore, it is most appropriate for long-term investments that have longer timelines to arriving at a decision. On the other hand CAMP is most appropriate when time is limited. In addition, at times it is not possible to determine the right factors, or even get the right data to do the APT model, in this case, the CAP is preferred (Connor & Korajczyk, 1986).
Therefore, CAMP main strength lies on its simplicity. This makes its more preferred since it is easy to use and arrive to a decision. As for APT its major strengths lies on its level of accuracy which is relatively high as it is able to impose more factors. Thus since APT is a multiple factor models it is an advanced form of CAMP. The major weakness of CAMP is its inability to encompass other factors that comprising reliability.
Conclusion
In conclusion, the analysis can delve to appreciating that APT is a more accurate model to CAMP. However, data in most cases is limited, and thus the use of either APT or CAMP largely relies on the ability to get data as well as determine the appropriate factors to use.
References
Connor, G., & Korajczyk, R. A. (1986). Performance measurement with the arbitrage pricing theory: A new framework for analysis. Journal of Financial Economics (JFE), 15(3).
Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of economic perspectives, 18(3), 25-46.
Roll, R., & Ross, S. A. (1980). An empirical investigation of the arbitrage pricing theory. The Journal of Finance, 35(5), 1073-1103.
Advanced Finance Part I
Question 1 part B
Explaining options and how they can be used as hedging instruments
Introduction
In the financial market, derivatives are the major operations. Derivatives can either be options, swaps or futures and forwards. We have two major forms of options including; call options, and the put options. As depicted by Kane & Marcus (1986) an option, is a derivative where two parties enter into a contract to make a sale or purchase of an asset at an agreed future price (Bodie et.al, 2015). The buyer gains the right to make a purchase. However they are not obliged to make the purchase when it is due. Thus through, the current analysis we will details into this options, their similarities and difference, and how the operate.
Option strategies
There are different forms of options including; stock, index, future, foreign currency, and interest rate options. Thus, there are different strategies that can be exercised including; combining both put and call options at varying prices, protective put, covered calls, straddles, spread, and collars. This st...