Arbitrage Pricing Theory and the Capital Asset Pricing Model: A Comparative Study in the Indian Scenario

Abstract


A comparative study of the Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM) was done in the Indian scenario on the lines of the methodology proposed by Chen (1983). A factor analysis (maximum likelihood method) was done on the daily returns data of selected scrips from the Mumbai Stock Exchange (BSE) to derive the factors. Sixteen factors emerged in the factor analysis and for the portfolio used in the comparative tests the t-test reported the factor loadings of five factors to be significantly different from zero. The regression ractual = arapt + (1 - a)rcapm was run where ractual, rapt, rcapm are the actual returns, APT predicted returns and CAPM predicted returns respectively. The resulting alpha value was close to one and in favor of APT. In the second test it was seen that while the APT was able to significantly explain the CAPM residuals, the CAPM was not able to significantly explain the APT residuals. Thus, the APT emerged the superior model in the tests.