Chartered Financial Analyst (CFA) Practice Exam Level 2

Which is a feature of Extended CAPM?

1. Includes a size premium

2. Assumes Purchasing Power Parity holds

3. Accounts for inflation adjustments

4. Uses historical market risk premium

The correct answer is: Assumes Purchasing Power Parity holds

Extended CAPM, or the Extended Capital Asset Pricing Model, goes beyond the traditional CAPM by incorporating additional factors that can affect asset pricing. One of the key features of Extended CAPM is its inclusion of a size premium. This reflects the idea that smaller firms tend to yield higher returns due to their added risk profile compared to larger firms, which is acknowledged in some forms of the Extended CAPM. The aspect of assuming Purchasing Power Parity holds is typically associated with foreign exchange or macroeconomic models rather than the adjustments made in Extended CAPM, which focuses primarily on equity pricing and risk factors. Furthermore, while inflation adjustments can be relevant, the essence of Extended CAPM is its structural approach to risk factors, rather than a direct adjustment for inflation like some other models. In summary, the standout feature of the Extended CAPM is its ability to incorporate additional risk factors such as size and value, offering a more nuanced perspective on expected returns than traditional CAPM, which only factors in market risk through beta.