Financial Risk Manager Part 1
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Which of the following statements is true regarding the security market line derived from the arbitrage pricing theory?
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TTanishq
A
It shows the expected return in relation to portfolio variance, represented by σ².
B
It has a downward slope.
C
The x-axis intercept is equal to the expected return on the market portfolio.
D
Any well-diversified portfolio may serve as the benchmark portfolio.
Explanation:
Explanation
The correct answer is D - Any well-diversified portfolio may serve as the benchmark portfolio.
Detailed Analysis:
Why D is correct:
- In Arbitrage Pricing Theory (APT), the benchmark portfolio does not necessarily have to be the market portfolio
- APT allows for multiple factors that influence security returns, not just the market return
- Any well-diversified portfolio can serve as the benchmark portfolio as long as it is diversified across the relevant factors
- This flexibility is a key distinction between APT and the Capital Asset Pricing Model (CAPM)
Why other options are incorrect:
A is incorrect: The security market line (SML) shows the relationship between systematic risk (beta) and expected return, not portfolio variance (σ²).
B is incorrect: The SML has an upward slope, not downward, indicating that higher systematic risk is associated with higher expected returns.
C is incorrect: The x-axis intercept of the SML represents the risk-free rate, not the expected return on the market portfolio.
Key Concept:
Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model that allows for multiple sources of systematic risk, making it more flexible than the single-factor CAPM. This flexibility extends to the choice of benchmark portfolios in APT applications.
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