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Answer: The CAPM assumes that all investors will make identical assumptions on the volatility and expected return of all available assets.
## Explanation **A is correct.** The Capital Asset Pricing Model (CAPM) assumes that all investors have homogeneous expectations, meaning they all make identical assumptions about the volatility (standard deviation) and expected return of all available assets. This is a key assumption that allows CAPM to derive the market portfolio as the optimal portfolio for all investors. **B is incorrect.** Arbitrage Pricing Theory (APT) describes an asset's expected return as having a **linear** relationship with several macroeconomic factors, not a nonlinear one. The APT model is: E(Ri) = Rf + βi1F1 + βi2F2 + ... + βikFk + εi **C is incorrect.** Both CAPM and APT assume investors are risk averse. CAPM specifically assumes investors are risk averse and only care about mean and variance of returns. APT relaxes some of CAPM's other assumptions but still assumes risk aversion. **D is incorrect.** APT explicitly includes an error term (εi) that captures idiosyncratic risk - the risk specific to individual assets that is not explained by the systematic factors. CAPM also acknowledges idiosyncratic risk through the alpha component.
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A portfolio manager at an investment management firm is developing a new portfolio strategy which incorporates various asset classes. The manager considers using both the arbitrage pricing theory (APT) model and the capital asset pricing model (CAPM) to analyze both the systematic and specific risks with these assets. Which of the following statements will the manager find to be correct about the given theory?
A
The CAPM assumes that all investors will make identical assumptions on the volatility and expected return of all available assets.
B
The APT describes an asset's return as having a nonlinear relationship with several market factors.
C
The APT assumes that investors are risk averse, while the CAPM does not.
D
Neither the APT nor the CAPM captures idiosyncratic risk that is not reflected in a factor exposure.