The costs of going from the APM to a macroeconomic
multifactormodelcanbetraceddirectlytotheerrorsthatcan
bemadeinidentifyingthefactors.Theeconomicfactorsin
themodelcanchange over time,as willtheriskpremium
associatedwitheachone.Forinstance,oilpricechangeswere
asignificanteconomicfactordrivingexpectedreturnsinthe
1970sbut were notas significantin the1980sand 1990s.
Usingthewrongfactor ormissinga significantfactorina
multifactormodelcanleadtoinferiorestimatesofexpected
return.
Allthreeriskandreturnmodelsmakesomeassumptionsin
common.Theyallassumethatonlymarketriskisrewarded
andtheyderivetheexpectedreturnasafunctionofmeasures
of this risk. The CAPM makes the most restrictive
assumptionsabouthowmarketsworkbutarrivesatthemodel
thatrequirestheleastinputs,withonlyonefactordrivingrisk
andrequiringestimation.TheAPMmakesfewerassumptions
butarrivesatamorecomplicatedmodel,atleastintermsof
theparametersthatrequireestimation.Ingeneral,theCAPM
hastheadvantageofbeingasimplermodeltoestimateandto
use, but it will underperform the richer APM when an
investment is sensitive to economic factors not well
represented inthemarketindex.Forinstance, oilcompany
stocks, which derive most of their risk from oil price
movements,tendtohavelowCAPMbetasandlowexpected
returns. Using an APM, where one of the factors may
measureoilandothercommoditypricemovements,willyield
abetterestimateofriskandhigherexpectedreturnforthese
firms.
4