The Comparison Between CAPM & APT
Both the capital asset pricing model (CAPM) and the arbitrage pricing theory (APT) are methods used to determine the theoretical rate of return on an asset or portfolio, but the difference between APT and CAPM lies in the factors used to determine these theoretical rates of return. CAPM only looks at the sensitivity of the asset as related to changes in the market, whereas APT looks at many factors that can be divided into either macroeconomic factors or those that are company specific.
The capital asset pricing model was created in the 1960s by Jack Treynor, William F. Sharpe, John Lintner and Jan Mossin in order to come up with a theoretical appropriate rate of return on an asset given the level of risk.
Economist Stephen Ross created the arbitrage pricing theory in 1975 as an alternative to the older CAPM, although APT is still largely based on CAPM. Ross's model incorporates a framework to explain the expected theoretical rate of return of an asset as a linear function of the risk of the asset, taking into account factors in order to accurately estimate market risk.
CAPM uses the risk-free rate of return (usually either the federal funds rate or a 10-year government bond yield), the beta of an asset in relation to the overall market, expected market return and investment risk in order to help quantify the projected return on an investment.
The beta of an asset measures the theoretical volatility compared to the overall market, meaning that if a portfolio has a beta of 1.5 compared to the S&P 500, then it is theoretically going to be 50 percent more volatile than the S&P.
APT in comparison to CAPM uses fewer assumptions and can be harder to use as well. The theory was developed with the assumption that the prices of securities are affected by many factors, which can be sorted into macroeconomic or company-specific factors.
A big difference between CAPM and the arbitrage pricing theory is that APT does not spell out specific risk factors or even the number of factors involved. While CAPM uses the expected market return in its formula, APT uses the expected rate of return and the risk premium of a number of macroeconomic factors. The APT formula uses a factor-intensity structure that is calculated using a linear regression of historical returns of the asset for the specific factor being examined.
APT is more accurate than CAPM since CAPM only looks at one factor and one beta, but it requires additional effort and time not only to calculate but also to determine what factors to use and to gather relevant data to find the beta in relation to each factor. On the other hand, it is not always possible to know the right factors or to find the right data, which is when CAPM may be preferred.
As a result, the decision of whether to use CAPM vs. APT should largely be dependent on whether you can actually determine the right factors to use and find the data to find the beta in relation to those factors in order to use APT, or if you are willing to settle for just knowing the difference between the risk-free rate of return and the expected market rate of return as you would if you use CAPM.