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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 key difference between the Arbitrage Pricing Theory (APT) and the single-factor CAPM?

APT lets multiple systematic factors drive expected returns and does not require the market portfolio to be mean-variance efficient or specify the factors. CAPM is a single-factor model that relies on an efficient market portfolio. Neither model prices idiosyncratic risk, since it can be diversified away.

  1. AAPT requires that all investors hold the market portfolio, whereas CAPM does not
  2. BAPT allows several systematic risk factors to explain expected returns, without specifying the factors or requiring the market portfolio to be mean-variance efficientCorrect
  3. CAPT states that idiosyncratic risk is priced, whereas CAPM states it is not
  4. DAPT holds only when markets are not competitive, whereas CAPM requires perfect competition

Explanation

APT assumes returns follow a linear factor structure and that no arbitrage exists in well-diversified portfolios. It does not name the factors or require the market portfolio to be efficient. CAPM relies on the market portfolio being mean-variance efficient. Idiosyncratic risk is not priced in either model.

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