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

Under two-fund separation in the CAPM setting with homogeneous expectations and a risk-free asset, which statement is correct about how a rational investor chooses a portfolio?

All investors hold the same risky portfolio, the tangency or market portfolio, and differ only in how much they put in the risk-free asset versus that portfolio. Risk aversion changes the lending or borrowing level, not the composition of the risky holdings.

  1. AAll investors hold the same mix of risky assets, and differ only in the proportion placed in the risk-free assetCorrect
  2. BInvestors with higher risk aversion hold a different set of risky assets with lower betas
  3. CEach investor selects a distinct tangency portfolio based on personal risk tolerance
  4. DOnly investors with low risk aversion hold the market portfolio

Explanation

With a risk-free asset and common beliefs, every investor holds the tangency portfolio (the market portfolio) of risky assets. Risk tolerance only determines the split between this portfolio and the risk-free asset, so the tangency portfolio does not vary by investor.

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