FRM Part II · FRM Exam Part II · Factor Theory
A portfolio manager explains to a client that the equity risk premium and the credit spread on corporate bonds are both compensation for exposure to bad economic states. Under the asset-based (consumption-based) view of factor theory, why do investors demand a positive premium for bearing such factor risk?
Investors demand a premium because the assets lose value in bad economic times, when an extra unit of wealth is most valuable to them (high marginal utility). Volatility alone or diversifiable idiosyncratic risk is not rewarded; it is the bad-times payoff pattern that matters.
- ABecause the factor returns are highly volatile in isolation, regardless of when they pay off
- BBecause the assets tend to perform poorly in bad times, when investors' marginal utility of wealth is highCorrect
- CBecause the assets have high idiosyncratic risk that cannot be diversified away
- DBecause the assets are expected to have returns that are perfectly correlated with inflation
Explanation
In the consumption-based view, a risk premium is earned by assets that pay off poorly when investors' marginal utility is high, such as recessions. Volatility alone or diversifiable idiosyncratic risk does not earn a premium, so those options are wrong.
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