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Posted on April 19th, 2014, by

Introduction

One of the most important steps in the process of evaluating investment opportunities is the assessment of risks associated with this investment and determining the acceptable rate of return which would cover these risks. There are different financial models for risk evaluation, and each of them has its own advantages and disadvantages. Key models are Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT) and Efficient Market Hypothesis (EMH). The purpose of this paper is to analyze the benefits and downsides of these models, its assumptions, challenges and spheres of application.

1. CAPM

Capital Asset Pricing Model (CAPM) is one of the most frequently used financial instruments for determining the appropriate return rate for securities or assets. CAPM states that the return of a stock portfolio or of an individual stock should be equal to its cost of capital, and can be expressed in the following form: , where  is the required rate of return,  is risk-free rate,  is the expected market return, and  is beta of the security (O’Regan, 2006). CAPM is effectively used for estimating the rate of return for assets and their required rate, and is therefore very convenient for financial decision-making.

CAPM relies on the following assumptions: all information is available to all investors at the same time, investors are risk-averse and rational, their investments are well diversified, and investors cannot influence market prices (O’Regan, 2006). However, CAPM also has the following challenges (O’Regan, 2006): 1) it assumes that variance of returns (beta) can be used for risk measurement; however, it is only possible when the distribution of the returns is normal, and in real life such ideal situation is not likely to be witnessed; and 2) CAPM does not manage to explain the stock return variation: e.g. stocks with low betas might show much higher returns than CAPM suggests. In addition to this, CAPM also focuses on portfolio optimization in the short-term horizon, while for many investors long-term optimization is more important.

2. APT

CAPM challenges with regard to beta as a measure of risk led to further development of linear models for risk evaluation, and later Arbitrage Pricing Theory (APT) has evolved. According to APT, expected return of a security or an asset can be modeled by the linear combination of macroeconomic indices associated with systematic factors multiplied by index-specific betas reflecting the sensitivity of an asset to particular economic factors (O’Regan, 2006). Overall, the APT can be expressed as follows: , where  is the estimated return rate,  is the constant in the linear model for the given asset,  is the sensitivity of the asset to the factor with number i, and  is the systematic economic factor with number i (O’Regan, 2006).

The assumptions of APT model include perfect competition in the market, the intention of investors to hold only traded assets, and the focus of investors on variance and mean return of investments. The main advantage of APT is that it allows to include the relevant economic factors into risk evaluation model (i.e. it does not limit the investor to market premium only, as CAPM does). APT also takes into account many risk sources, which allows to better reflect the real world (Choudhry, 2002). At the same time, APT requires a lot of long-term data and factor-related information to assess systematic factors and betas of the asset; in other words, for correct risk evaluation, APT requires a lot of statistics and deals with a lot of statistical noise compared to other models.

3. EMH

The Efficient Market Hypothesis (EMH) states that markets are already efficient with regard to information, which implies that current market prices on assets are formed by shared knowledge of investors, and represent the optimal equilibrium. In other words, according to EMH, it is not possible to beat the market because of its efficiency. EMH also states that markets are both cost efficient and risk efficient, and it is not to significantly increase the efficiency of the investments compared to market rates. There are three forms of EMH: weak states that asset prices also reflect past volume information and past pricing; semi-strong states that asset prices already contain all information which is publicly available, and strong asset prices reflect both private and public information quickly, and the market is in fact unbeatable (Choudhry, 2002).

The assumptions of EMH are informational efficiency of financial markets and rational behavior of agents both in the short-term and in the long-term perspective. EMH provides explanations and background for passive and cost-effective financial management, and gives good reasoning for passive investment (Choudhry, 2002). On the other hand, the assumptions of EMH might not always hold or might hold partially: EMH does not explain superior effectiveness of individual investors such as  Warren Buffet, and does not provide good explanations for different portfolio effectiveness of different investors. Therefore, EMH mostly explains the markets with perfect efficiency, while in real-life conditions market efficiency might be high, but still limited.

Conclusion

The analysis of different models and theories of risk assessment shows that risk is a complex phenomenon and all three models have specific advantages of challenges. The choice of the model for risk assessment is conditioned by the time period of the investment, portfolio status, information available and other factors. In general cases, it might be useful to consider risk assessment using all three models if enough information is available, since different models evaluate different aspects of investment risk.

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