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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 is a core assumption of the Arbitrage Pricing Theory (APT) that distinguishes it from the CAPM?

APT assumes asset returns are generated by a linear model of several systematic factors plus idiosyncratic noise, and that idiosyncratic risk diversifies away in large portfolios. Unlike the CAPM, it does not require the market portfolio to be efficient or investors to be mean-variance optimizers.

  1. AAll investors hold the market portfolio and have identical mean-variance preferences
  2. BAsset returns are driven by several systematic factors, and idiosyncratic risk can be diversified away in large portfoliosCorrect
  3. CExpected returns depend only on total standard deviation
  4. DThe market portfolio must be mean-variance efficient for the model to hold

Explanation

APT assumes returns follow a linear factor model with systematic factors plus idiosyncratic noise, and that well-diversified portfolios eliminate idiosyncratic risk. It does not require the market portfolio to be efficient or that investors be mean-variance optimizers. The other options describe CAPM-type assumptions or are incorrect.

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