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FRM Part I · FRM Exam Part I · The Arbitrage Pricing Theory and Multifactor Models of Risk and Return

Which of the following best describes a key difference between the Arbitrage Pricing Theory (APT) and the Capital Asset Pricing Model (CAPM)?

APT allows several systematic risk factors to determine expected returns, while CAPM uses only the market portfolio's beta as a single factor. APT rests on no-arbitrage in well-diversified portfolios, and neither model prices idiosyncratic risk, which is diversified away.

  1. AAPT requires all investors to hold the market portfolio, whereas CAPM does not
  2. BAPT allows multiple systematic factors to drive expected returns, whereas CAPM relies on a single market factorCorrect
  3. CAPT assumes that idiosyncratic risk is priced, whereas CAPM assumes it is not
  4. DAPT requires mean-variance optimizing investors, whereas CAPM relies only on no-arbitrage

Explanation

CAPM is a single-factor equilibrium model in which only market beta is priced and investors are mean-variance optimizers holding the market portfolio. APT relies on no-arbitrage and permits several systematic factors. Idiosyncratic risk is not priced in either model, so the third option is wrong.

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