Investment Case

(1) Discuss the advantages of arbitrage pricing theory (APT) over the capital asset pricing model (CAPM) relative to diversified portfolios.

• The APT does not require that the benchmark portfolio in the Securities Market Line (SML) relationship be the true market portfolio. Any well-diversified portfolio lying on the SML may serve as a benchmark portfolio, so the APT is more flexibility than the CAPM does, because problems associated with an unobservable market portfolio are not concern.

• The APT provides further justification for use of the index model for practical implementation of the SML relationship. Specifically, if the index portfolio is not a precise proxy for the true market portfolio, which is a cause of considerable concern in the context of the CAPM, if the index portfolio is sufficiently diversified, the SML relationship holds, according to APT.

• The APT serves many of the functions as the CAPM. It shows a benchmark for rates of return that can be used in capital budgeting, security valuation, or investment performance evaluation. Meanwhile, the APT highlights the crucial distinction between non-diversifiable risk that requires a reward in the form of a risk premium and diversifiable risk that does not.

• The APT is an extremely appealing model. It depends on the assumption that a rational equilibrium in capital markets precludes arbitrage opportunities. In contrast, the CAPM is derived assuming an inherently unobservable “market” portfolio.

(2) Why might the degree of market efficiency differ across various markets? State three reasons why this might occur and explain each reason briefly.

• Information provided is not sufficient and efficient enough:

For example:

o The strong form can