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FRM Part I · FRM Exam Part I · Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)

Roll's critique of CAPM tests argues that which of the following is true?

Roll's critique says CAPM cannot be properly tested because the true market portfolio of all assets is unobservable. Tests use a proxy like an equity index, so they jointly test CAPM and the proxy's mean-variance efficiency, and rejection may reflect a bad proxy rather than a flawed theory.

  1. ABeta cannot be estimated using regression on historical returns
  2. BThe CAPM is untestable in practice because the true market portfolio, including all assets, is unobservable, so tests are really joint tests of CAPM and the proxy's efficiencyCorrect
  3. CThe CAPM holds only if the risk-free rate is zero
  4. DEmpirical rejection of CAPM proves that investors are irrational

Explanation

Roll argued that the theoretical market portfolio includes all assets (human capital, real estate, etc.), so any test uses a proxy such as an equity index. A rejection may reflect an inefficient proxy rather than a failure of the theory. The other options are not part of his argument.

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