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

Which of the following is a standard criticism of the single-period CAPM when it is applied to real-world markets?

A standard criticism is that CAPM assumes homogeneous expectations and unlimited borrowing and lending at the risk-free rate. These assumptions are unrealistic. CAPM actually prices systematic risk through beta, not total or unsystematic risk, and its market portfolio covers all risky assets, not just domestic equities.

  1. AIt assumes investors have homogeneous expectations and can borrow and lend unlimited amounts at the risk-free rateCorrect
  2. BIt assumes that investors care only about unsystematic risk when pricing assets
  3. CIt requires that the market portfolio contain only equities in the investor's home country
  4. DIt implies that expected returns depend on total risk (standard deviation) rather than beta

Explanation

CAPM rests on assumptions such as homogeneous expectations, a single period, no taxes or transaction costs, and unlimited borrowing and lending at the risk-free rate. These are widely criticized as unrealistic. The other options misstate CAPM: it prices systematic risk (beta), not total or unsystematic risk, and the market portfolio includes all risky assets.

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