The Risk-Adjusted Return Theory Ii: Comparing it to Other Asset Pricing Models

Abstract

In this paper, we exploit new features of the Risk-adjusted Return Theory (RART) by contrasting it with the Capital Asset Pricing Model (CAPM). We define some concepts similar to ones in the CAPM. Also, we model an asset pricing by a multiple regression and call this model a regression asset-pricing model (RAPM). We study the relation between the RART and the RAPM, concluding that the RART implies the RAPM and the RAPM implies Ross's Asset Pricing Theory (APT) if the betas in the APT are estimated with a regression. We construct and explain Fama and French's three-factor model by the RART, giving the model sound economic logic. Finally, we identify the limitation most factor models have.

Keywords: APT, CAPM, risk-adjusted return, risk budget, asset pricing, three-factor model, multiple regression, tracking error, portfolio management, asset allocation