Skip to content

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

Which empirical finding is most clearly inconsistent with the CAPM's prediction that beta alone explains cross-sectional differences in expected returns?

The size effect, where small-cap stocks earned more than their betas predict, contradicts the CAPM. It indicates that characteristics other than market beta explain expected returns, which motivated multifactor models such as Fama-French.

  1. AStocks with higher betas tend to have higher volatility
  2. BSmall-capitalization stocks have historically earned returns higher than their betas would predictCorrect
  3. CThe market portfolio has a beta of 1
  4. DExpected returns are linear in beta along the security market line

Explanation

The size effect shows a return premium unexplained by beta, contradicting the claim that only systematic market risk is priced. The other options are either consistent with or are definitional in the CAPM.

Did you get it right without looking?

One question tells you little. A timed set on Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM) shows your real accuracy, how long you take and where you lose marks.

Practise Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)Free diagnostic mock

More Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM) questions