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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 the CAPM argues that the model cannot be empirically tested mainly because:

Roll's critique says the CAPM is essentially untestable because the true market portfolio includes every risky asset and cannot be observed. Tests using a stock index only assess whether that proxy is mean-variance efficient, not whether the CAPM itself holds.

  1. AThe true market portfolio must contain all risky assets and is unobservable, so tests using a proxy are really tests of the proxy's efficiencyCorrect
  2. BInvestors have differing borrowing and lending rates, which makes the security market line nonlinear
  3. CBetas are always unstable over time, so they cannot be estimated
  4. DReturns are not normally distributed, so variance is not a valid risk measure

Explanation

Roll argued the CAPM's only testable implication is that the true market portfolio is mean-variance efficient. That portfolio includes all assets (human capital, real estate, etc.) and cannot be observed. Using an index proxy therefore tests the proxy, not the theory. The other options describe different criticisms or extensions, not Roll's point.

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