Question

Investment in production agriculture has been claimed to be low risk.

A. Explain how the risk premium associated with each systemic risk factor is estimated with the Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) models. Also, list two similarities and two differences between both models.

Answer 1

A. CAPM uses a single risk factor to estimate the risk premium . The single risk factor is the beta.

Formula is :

Re = Rf + beta(Rm - Rf)

The APT model uses a several systematic risk premium instead of a single factor,

Formula for APT is :

Re = Rf + beta*FP1 + beta*FP2 + ..........

Here FP1 = Risk premium associated with the first risk factor

FP2 = Risk premium associated with the 2nd risk factor

Similarities is that both of these models calculate  the expected return by the investor.

APT was developed as an extension of the CAPM Model.

The difference is that while the CAPM just uses a single risk factor which is the beta, the APT uses multiple risk factors which are macroeconomic factors while calculating the required return.

Contrary to the CAPM, APT model assumes that the markets are not completely efficient and mis-pricing happens from time to time. It uses fewer assumptions but is harder to implement than the CAPM. It's assumptions are far more realistic than the CAPM, but it is quite complex in comparison to the CAPM due to is multiple factors.