Skip to content

FRM Part II · FRM Exam Part II · Factor Theory

A portfolio manager regresses monthly excess returns of a fund on three factors (market, size, value). The regression R-squared is 0.85. Which statement best interprets this result for risk decomposition?

An R-squared of 0.85 means 85% of the fund's return variance is explained by its factor exposures, which is systematic factor risk, while the remaining 15% is idiosyncratic or specific risk that the factors do not capture.

  1. A85% of the fund's return variance is explained by factor exposures and 15% is attributed to idiosyncratic (specific) riskCorrect
  2. B85% of the fund's return each month is generated by alpha
  3. C15% of the fund's variance is systematic and 85% is diversifiable
  4. DThe fund's alpha equals 0.85 percent per month

Explanation

R-squared measures the share of return variance explained by the factors, i.e., systematic factor risk. The remainder (1 - 0.85 = 15%) is residual or specific risk. Option 3 reverses the two components.

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.

Practise Factor TheoryFree diagnostic mock

More Factor Theory questions