can be used in capital budgeting, security evaluation, or investment per- formance evaluation. Moreover, the APT highlights the crucial distinction between nondi- versifiable risk (factor risk) that requires a reward in the form of a risk premium and diversifiable risk that does not.       11.4 THE APT AND THE CAPM   The APT is an extremely appealing model. It depends on the assumption that a rational equilibrium in capital markets precludes arbitrage opportunities. A violation of the APTs pricing relationships will cause extremely strong pressure to restore them even if only a limited number of investors become aware of the disequilibrium. Furthermore, the APT yields an expected return-beta relationship using a well-diversi- fied portfolio that practically can be constructed from a large number of securities. In con- trast, the CAPM is derived assuming an inherently unobservable "market" portfolio. In spite of these appealing advantages, the APT does not fully dominate the CAPM. The CAPM provides an unequivocal statement on the expected return-beta relationship for all III. Equilibrium In Capital Markets 11. Arbitrage Pricing Theory The McGraw−Hill Companies, 2001           332 PART III Equilibrium in Capital Markets     assets, whereas the APT implies that this relationship holds for all but perhaps a small num- ber of securities. This is an important difference, yet it is fruitless to pursue because the CAPM is not a readily testable model in the first place. A more productive comparison is between the APT and the index model. Recall that the index model relies on the assumptions of the CAPM with the additional assumptions that (1) a specified market index is virtually perfectly correlated with the (un- observable) theoretical market portfolio; and (2) the probability distribution of stock re- turns is stationary, so that sample period returns can provide valid estimates of expected returns and variances. The implication of the index model is that the market index portfolio is efficient and that the expected return-beta relationship holds for all assets. The assumption that the proba- bility distribution of security returns is stationary and the observability of the index make it possible to test the efficiency of the index portfolio and the expected return-beta rela- tionship. The arguments leading from the assumptions to these