The arbitrage pricing theory (APT) posits that the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line. In the context of APT, the benchmark portfolio does not necessarily have to be the market portfolio. It can be any well-diversified portfolio. This is because, in APT, we are looking at multiple factors that influence the return of a security, not just the market return. Therefore, the benchmark portfolio can be any portfolio that is well-diversified across these factors. This means that the portfolio should have a mix of securities that are influenced by these factors in different ways, so that the overall risk of the portfolio is minimized.

Choice A is incorrect. The security market line (SML) does not show the expected return in relation to portfolio variance. Instead, it depicts the relationship between systematic risk (beta) and expected return of a security or a portfolio.

Choice B is incorrect. The SML does not have a downward slope; rather, it has an upward slope indicating that higher risk (beta) is associated with higher expected returns.

Choice C is incorrect. The y-intercept of the SML is equal to the risk-free rate, not the expected return on the market portfolio.

Things to Remember

• Arbitrage Pricing Theory (APT) is an alternative to the Capital Asset Pricing Model (CAPM) and suggests that the expected return of a financial asset is based on multiple macroeconomic factors, each with its own beta coefficient.

• The Security Market Line (SML) is a graphical representation of the CAPM and shows the relationship between systematic risk (beta) and expected return.

• The slope of the SML is upward, indicating that higher risk is associated with higher expected returns.