Tom Ace, an equity analyst, uses the capital asset pricing model (CAPM) to help identify mispriced securities. A consultant advises Tom Ace to use arbitrage pricing theory (APT) instead. In comparing CAPM and APT, the consultant makes the following arguments:

I. APT places more emphasis on market risk.

II. Neither the CAPM nor the APT assumes investors are mean-variance optimizers.

III. APT specifies the number and identifies specific factors that determine expected returns.

IV. APT does not require restrictive assumptions concerning the market portfolio.

Criticize the four arguments made by the consultant.

Question

Tom Ace, an equity analyst, uses the capital asset pricing model (CAPM) to help identify mispriced securities.  A consultant advises Tom Ace to use arbitrage pricing theory (APT) instead.  In comparing CAPM and APT, the consultant makes the following arguments:

I. APT places more emphasis on market risk.

II. Neither the CAPM nor the APT assumes investors are mean-variance optimizers.

III. APT specifies the number and identifies specific factors that determine expected returns.

IV. APT does not require restrictive assumptions concerning the market portfolio.

Criticize the four arguments made by the consultant.

BlackTom AI · Accepted Answer

When evaluating the consultant's four statements about CAPM vs APT, I examine each one for accuracy against foundational theory.
Option 1: 'APT places more emphasis on market risk.' In fact, the CAPM centers on market risk as captured by beta, while APT uses multiple factors beyond a single market factor. Therefore this claim overstates APT's focus on market risk and is incorrect.
Option 2: 'Neither the CAPM nor the APT assumes investors are mean-variance optimizers.' The CAPM is derived under the assumption that investors are mean-variance optimizers, so this statement is false. The APT does not require mean-variance optimization to hold, but CAPM does, at least in its standard derivation.
Option 3: 'APT specifies the number and identifies specific factors that determine expected returns.' APT does not specify a fixed set or number of factors; it allows for multiple factors and remains flexible about which factors matter. This makes the statement incorrect.
Option 4: 'APT does not require restrictive assumptions concerning the market portfolio.' This aligns with the core advantage of APT: it relaxes the rigid assumptions about a market portfolio that CAPM imposes (e.g., all investors hold the market portfolio, homogenous expectations). Hence this claim is correct.
In summary, the first three statements mischaracterize APT or CAPM in important ways, while the fourth accurately states a key feature of APT. The evaluation shows that only the fourth option aligns with established theory.

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