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

Under the Capital Market Line (CML) framework with homogeneous expectations, which statement best describes two-fund separation?

Two-fund separation means all investors hold the same risky portfolio, the tangency or market portfolio, combined with the risk-free asset. Risk aversion affects only the weights between those two funds, not the composition of the risky holdings.

  1. AEvery investor holds the same mix of risky assets, and differences in risk aversion affect only the split between the risk-free asset and that risky portfolioCorrect
  2. BEvery investor holds the minimum-variance portfolio, and differences in risk aversion determine the number of assets held
  3. CInvestors with higher risk aversion hold a different risky portfolio with more low-beta stocks than less risk-averse investors
  4. DInvestors choose between the risk-free asset and a single stock selected by their risk preference

Explanation

With homogeneous expectations all investors identify the same tangency (market) portfolio of risky assets. Risk aversion only determines how much is placed in the risk-free asset versus the tangency portfolio. The idea that risky portfolio composition varies with risk aversion contradicts separation.

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