Explanation:
A is correct. CAPM assumes that all market participants have the same expectations and make their investment decisions based on the mean and variance of returns.
B is incorrect. According to the APT, an asset’s expected rate of return is a linear function of several factors.
C is incorrect. The CAPM assumes investors are risk averse and only invest based on the mean and variance of returns. The APT relaxes that assumption.
D is incorrect. The APT includes a noise factor for idiosyncratic risk.
Learning Objective: Explain the Arbitrage Pricing Theory (APT), describe its assumptions, and compare the APT to the CAPM.
Reference: Global Association of Risk Professionals. Foundations of Risk Management. New York, NY: Pearson, 2023, Chapter 6, The Arbitrage Pricing Theory and Multifactor Models of Risk and Return [FRM-6].
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Question 46: 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.
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