An Introduction to Financial Markets

Chapter Ten Equilibrium Models: CAPM and APT

This chapter might be regarded as an outgrowth of Chapter 9 on factor models, as there is a clear relationship between single and multiple factor models and the equilibrium models we treat here. The single-index model is related with the capital asset pricing model (CAPM), and multifactor models are related with ar bitrage pricing theory (APT). However, equilibrium models require much more than a statistical model, as they rely on crucial assumptions about investors’ behavior. If we accept these assumptions, we find quite drastic conclusions. For instance, CAPM implies that there is no point in pursuing active portfolio management, based on stock-picking or market-timing strategies. There is no specific risk premium, and we should just follow a passive strategy tracking the market portfolio. A fierce debate revolves around this conclusion, and it is related to conflicting views about market efficiency and investors’ rationality. More generally, the view behind equilibrium models is challenged by the behavioral approach to finance. It is interesting to notice that the behavioral approach, per se, is not necessarily incompatible with the use of quantitative factor-based models.

Taken literally, the assumptions behind CAPM are rather hard to accept, as we shall see. APT is a bit less demanding than CAPM in terms of critical as sumptions, but it is much less specific in its consequences, as it does not specify the factors that we should ...