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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Which assumption is part of the basic mean-variance framework used to construct the efficient frontier?

The basic mean-variance framework assumes investors evaluate portfolios solely by the expected return and variance of return over a single period, and are risk-averse. It does not assume perfect correlation, risk-seeking behaviour or significant taxes and transaction costs.

  1. AInvestors are risk-seeking and maximise variance
  2. BInvestors judge portfolios only by expected return and variance of return over a single periodCorrect
  3. CAsset returns must be perfectly positively correlated
  4. DInvestors have different beliefs about expected returns and covariances
  5. Transaction costs and taxes are important determinants of choice

Explanation

The framework assumes investors are rational and risk-averse, consider a single period, and use only the mean and variance of returns. It does not require perfect correlation, and it ignores taxes and transaction costs. Homogeneous beliefs are usually assumed for CAPM, not heterogeneous ones.

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