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Answer: MPT assumes that investors ignore the skewness of a return distribution.
## Explanation **A is correct.** Modern Portfolio Theory (MPT) assumes that investors focus only on the mean and variance of returns, ignoring the skewness of return distributions. This is a significant concern in practice because: - **Skewness matters in asset pricing**: Studies by Campbell Harvey, and Bekaert and Harvey have shown that skewness of return distributions is important in asset pricing decisions - **Inaccurate estimates**: By ignoring skewness, the estimated mean and variance of returns will be incorrect - **Real-world limitations**: Return distributions in financial markets often exhibit skewness, which MPT fails to account for **B is incorrect** because MPT actually assumes return distributions are symmetric (normal distribution), not asymmetric. **C is incorrect** because this describes Arbitrage Pricing Theory (APT) or factor models like Fama-French, not MPT. **D is incorrect** because MPT recognizes that diversification can only eliminate idiosyncratic (unsystematic) risk, not systematic risk. Systematic risk affects all securities and cannot be diversified away.
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A risk analyst at a bank is assessing modern portfolio theory (MPT) and the validity of applying MPT in asset pricing. The risk analyst begins by evaluating the assumptions underlying MPT. Which of the following is correct for the analyst to identify as a concern when applying MPT in practice?
A
MPT assumes that investors ignore the skewness of a return distribution.
B
MPT assumes that return distributions are asymmetric.
C
MPT assumes that asset returns can be explained by a small number of systematic factors that affect all securities.
D
MPT assumes that by using diversification, investors can eliminate both systematic and idiosyncratic risks from their portfolios.
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