Chartered Financial Analyst (CFA) Practice Exam Level 2

What does the Arbitrage Pricing Theory (APT) primarily focus on?

1. Risk-return relationships

2. Market volatility analysis

3. Investor behavioral finance

4. Asset pricing models

The correct answer is: Risk-return relationships

The Arbitrage Pricing Theory (APT) primarily focuses on the relationships between risk and return in the context of asset pricing. It posits that the return on an asset can be modeled as a linear function of various macroeconomic factors or theoretical risks, akin to the risk-return framework established in the Capital Asset Pricing Model (CAPM) but with greater flexibility regarding the number of factors used. APT introduces several systematic risk factors that influence the returns on assets, thus allowing investors to assess expected returns based on the risk exposure to those factors. This theory underscores the importance of understanding how the returns are affected not just by the market risk but also by specific risk factors that can impact asset performance. While other concepts such as market volatility analysis, behavioral finance, and various asset pricing models might be related to or incorporate elements of risk and return, the central theme of APT is its direct concern with establishing a relationship between the returns on securities and their sensitivities to multiple sources of systematic risk. This foundational aspect is what makes APT a crucial concept in finance, particularly in portfolio management and risk assessment.