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IAI Actuarial Core Principles · Economic Modelling · Single and multifactor models for investment returns

Which statement best describes how the Arbitrage Pricing Theory (APT) differs from the CAPM when applied to explaining investment returns?

APT allows several systematic risk factors to drive returns but does not specify what those factors are. This flexibility is a strength, though the lack of identified factors is a practical limitation compared with CAPM.

  1. AAPT requires investors to hold only the market portfolio
  2. BAPT allows several systematic risk factors but does not specify what those factors areCorrect
  3. CAPT assumes that all investors have quadratic utility
  4. DAPT states that only unsystematic risk is priced
  5. APT requires that returns are normally distributed

Explanation

APT is a multifactor framework in which expected returns depend linearly on several systematic factors, but the theory does not identify them, which is a practical limitation. CAPM relies on the market portfolio and mean-variance preferences. Neither theory prices unsystematic risk.

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