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FRM Part I · FRM Exam Part I · The Arbitrage Pricing Theory and Multifactor Models of Risk and Return

A manager claims a positive alpha for a fund based on a single-factor market model. A risk analyst re-estimates the model with additional factors (size and value) and finds the fund's alpha falls to near zero. What is the most appropriate interpretation?

The original alpha partly reflected compensation for exposures to omitted risk factors, not skill. When size and value factors are added, the return they explain is removed from alpha, so alpha is sensitive to model specification and shrinks toward zero.

  1. AThe earlier alpha partly reflected compensation for exposure to omitted risk factors rather than skillCorrect
  2. BThe additional factors prove the fund has negative skill
  3. CThe original alpha was correct, since adding factors can never change alpha
  4. DThe fund must be hedged by shorting the market only

Explanation

In a multifactor model, returns attributed to alpha in a misspecified model may actually be factor premia from omitted exposures. Adding factors reassigns that return to factor exposure. It does not imply negative skill, and alpha estimates do change with model specification.

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