While CAPM is using a single-factor model, the arbitrage pricing model (APT) uses multi-factor models. You can use multiple factors to describe how you can get returns for risk assets. While CAPM restricts the risks into one source, the multi-factor model can have risks from various aspects. How do you curb that? In this article at AnalystPrep, James Forjan shares how multi-factor models influence the returns of risk-adjusted assets.
Assumptions of APT
- You can define the asset returns using systematic factors.
- You cannot buy a lesser-priced asset and sell it at a higher price.
- By diversifying the assets, you can discard certain risks from the portfolio.
Multi-factor Models and CAPM
With these financial models, you can determine the portfolio rate of returns and pricings of separate stocks. On the other hand, CAPM uses only the market factor to figure out the return. When you split a single factor based on macroeconomic aspects, you get multiple factors.
Though a single-factor model takes into consideration just one macroeconomic factor, multi-factor models depend on several. For instance, evolving GDP rates in the market and fluctuating interest rates.
While you can eliminate certain risks by diversifying the portfolio, you can remove systematic risks only through hedging. ‘Each factor can be regarded as fundamental security and can, therefore, be utilized to hedge the same factor relative to given security’. Forjan has shared three case studies for easy reference.
The Three-Factor Model
The Fama and French three-factor model has overtaken the APT model because of its broader risk factor coverage. The new model depends on the size of the firms you are investing in. It also includes the book-to-market values and excess return on the market. Here are easy formulae to calculate for the model:
Firm Size Factor = Difference in returns between portfolios of high and low book-to-market firms
Book-to-Market Value Factor = Difference in returns between portfolios of high and low book-to-market firms
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