Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

Which of the following terms is associated with portfolio management and investment strategies?

1. Arbitrage pricing theory

2. Efficient market hypothesis

3. Modern portfolio theory

4. Capital asset pricing model

The correct answer is: Modern portfolio theory

Modern portfolio theory is a fundamental concept in portfolio management and investment strategies, developed by Harry Markowitz in the 1950s. It emphasizes the importance of diversification to optimize the risk-return trade-off within an investment portfolio. By considering the correlation between different asset classes, investors can create a portfolio that maximizes expected returns for a given level of risk or minimizes risk for a given level of expected return. The essence of modern portfolio theory lies in the idea that not all risk is equal. It distinguishes between systematic risk, which affects the overall market, and unsystematic risk, which is specific to individual investments. According to this theory, a well-constructed portfolio can achieve higher returns while maintaining a controlled level of risk through the strategic selection of assets. While arbitrage pricing theory, efficient market hypothesis, and capital asset pricing model are all important concepts in finance and investment, they focus on different aspects. Arbitrage pricing theory relates to asset pricing and the identification of arbitrage opportunities. The efficient market hypothesis pertains to market efficiency and the inability to consistently achieve higher returns than the average market return. The capital asset pricing model helps determine expected return based on systematic risk, specifically using the market's beta. However, modern portfolio theory addresses the practical application of combining