FRM Part II · FRM Exam Part II · Factor Theory
A portfolio manager explains that equity returns are higher on average than government bond returns because equities perform poorly in bad economic times, when investors' marginal utility of wealth is high. Under the asset pricing framework in Factor Theory, which statement best describes this reasoning?
Premiums compensate for systematic risk, meaning payoffs that are weak in bad times when marginal utility is high. Diversifiable idiosyncratic risk earns no premium, so total volatility is not the basis for expected returns in the asset pricing framework.
- AAssets earn risk premiums for bearing systematic risk that is correlated with bad times, not for idiosyncratic riskCorrect
- BAssets earn premiums in proportion to their total volatility, including diversifiable risk
- CRisk premiums arise only from mispricing that arbitrageurs eventually eliminate
- DRisk premiums are determined solely by an asset's liquidity and not by its covariance with the stochastic discount factor
Explanation
In the SDF framework, an asset's expected excess return depends on its covariance with the stochastic discount factor, which is high in bad times. Assets that pay off poorly then require higher expected returns. Idiosyncratic risk can be diversified and earns no premium, so total volatility is the wrong basis.
Did you get it right without looking?
One question tells you little. A timed set on Factor Theory shows your real accuracy, how long you take and where you lose marks.
More Factor Theory questions
- A portfolio has two uncorrelated factor exposures, A and B, with volatilities of 4% and 12% respectively. A manager wants equal risk contrib…
- A fund holds two uncorrelated factor sleeves with equal capital. Sleeve A has volatility 10% and sleeve B has volatility 20%. The manager wa…
- An investor builds a two-factor portfolio with 50% in a value factor and 50% in a momentum factor. Each factor has volatility of 10% and the…
- An asset owner replaces a market-capitalization-weighted equity benchmark with a smart beta index that tilts toward stocks with low price-to…
- A portfolio has exposures of 0.8 to Factor A and 0.5 to Factor B. Factor premiums over the period were A: 4% and B: -2%. The portfolio's tot…
- A risk manager reviews a smart beta ETF whose backtest shows strong factor returns but whose assets under management have grown tenfold. Whi…