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FRM Part I · FRM Exam Part I · Modern Portfolio Theory (MPT) and the Capital Asset Pricing Model (CAPM)

A portfolio manager uses a single-factor CAPM regression on excess returns and obtains an intercept of 0.20% per month with a standard error of 0.15%, and a beta of 0.8 on market excess return. Later, adding the Fama-French size and value factors, the intercept falls to 0.03% with a standard error of 0.15%, and the size and value loadings are significantly positive. Which interpretation is best?

Neither intercept is statistically significant (t of about 1.33 and 0.2), and alpha shrinks when size and value factors are added. This shows most of the apparent CAPM alpha is compensation for factor exposures rather than manager skill.

  1. AThe manager has skill because the CAPM alpha is positive and the three-factor model confirms it
  2. BThe CAPM regression is invalid because beta is less than 1
  3. CMost of the apparent CAPM alpha is compensation for exposure to size and value factors, and neither intercept is statistically significantCorrect
  4. DThe extra factors increased risk, so the manager's alpha rose in significance

Explanation

The t-statistic for the CAPM intercept is 0.20/0.15 = 1.33, not significant at conventional levels. The three-factor intercept gives t = 0.03/0.15 = 0.2. The drop in alpha with significant size and value loadings shows the return came from factor exposure, not skill. Option 1 ignores both the insignificance and the drop.

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