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

Which statement best describes a core assumption of the Arbitrage Pricing Theory (APT) as applied to a well-diversified portfolio?

APT assumes returns are linear in systematic factors and idiosyncratic risk is diversified away, so only factor exposures earn risk premiums. Absence of arbitrage among well-diversified portfolios then ties expected returns to factor betas, not to total volatility or a single market portfolio.

  1. AInvestors hold only the market portfolio and care solely about its mean and variance
  2. BReturns are generated by a linear function of systematic factors, and idiosyncratic risk is diversified away so it earns no risk premiumCorrect
  3. CEvery asset must have a beta of exactly one to the market factor
  4. DExpected returns depend on each asset's total standard deviation

Explanation

APT assumes returns follow a linear factor model and that firm-specific risk can be diversified away. Because no-arbitrage must hold for well-diversified portfolios, only factor exposures are priced. Option A describes CAPM-type reasoning, and total volatility is not priced under APT.

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