In one of their empirical tests of the APT, Roll and Ross examined the relationship between a security's returns and its own standard deviation. A finding of a statistically significant relationship would indicate that
A) APT is valid because a security's unsystematic component would be eliminated by diversification.
B) APT is valid because non-diversifiable components should be explained by factor sensitivities.
C) APT is invalid because a security's unsystematic component would be eliminated by diversification.
D) APT is invalid because standard deviation is not an appropriate factor.
E) None of these are correct.

Question

Quizplus · Accepted Answer

A statistically significant relationship between a security's returns and its own standard deviation would indicate that the APT is invalid because it suggests that the security's unsystematic component, which should be eliminated by diversification, is having an impact on its returns. This contradicts the assumptions of the APT, which assumes that diversification eliminates unsystematic risk, leaving only non-diversifiable risk (systematic risk), which should be explained by factor sensitivities. Therefore, a statistically significant relationship between a security's returns and its own standard deviation would suggest that there is unsystematic risk that is not accounted for by the APT.

In One of Their Empirical Tests of the APT, Roll