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Answer: MPT assumes asset returns are normally distributed, but empirical evidence shows that return distributions are typically asymmetric with fat tails.
**Correct Answer: B** **Explanation:** B is correct. Although MPT was an important breakthrough in the theory of portfolio selection, there are major concerns about the unwarranted assumptions underlying the theory and the issues associated with applying the theory in practice. For example, the assumption that returns are normally distributed is a major concern. The preponderance of empirical evidence across different asset classes and countries fails to support the assumption that asset returns are normally distributed. These studies show that return distributions have fat tails (i.e., there are more observations in the tails of the distribution than a normal distribution) and are asymmetric. A is incorrect. The theory assumes that returns are normally distributed, but empirical evidence shows that return distributions are asymmetrically distributed and fat-tailed. C is incorrect. Empirical evidence shows that return distributions are fat-tailed. D is incorrect. The theory assumes that returns are normally distributed. **Learning Objective:** Explain Modern Portfolio Theory and interpret the Markowitz efficient frontier. **Reference:** Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, Chapter 5. Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM) [FRM-5].
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A risk analyst at a bank is assessing the suitability of applying modern portfolio theory (MPT) in portfolio analysis. The analyst starts by evaluating the assumptions underlying MPT. Which of the following is correct for the analyst to identify as a concern about the application of MPT in practice?
A
MPT assumes asset returns are asymmetric with fat tails, but empirical evidence shows that return distributions are typically normally distributed.
B
MPT assumes asset returns are normally distributed, but empirical evidence shows that return distributions are typically asymmetric with fat tails.
C
MPT assumes asset returns are normally distributed, but empirical evidence shows that return distributions are typically asymmetric with thin tails.
D
MPT assumes asset returns have negative skewness, but empirical evidence shows that return distributions typically exhibit positive skewness and fat tails.
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