FRM Part II · FRM Exam Part II · Factor Theory
A risk analyst at an asset manager is explaining why the market portfolio's return is not the only source of systematic risk premium. Under the factor-theory view of asset pricing, which of the following best describes why an investor earns a risk premium for holding a particular factor?
Investors earn a factor risk premium because the factor tends to perform poorly in bad economic times, when an extra unit of wealth is most valuable. This is compensation for bearing systematic, non-diversifiable risk. Idiosyncratic risk that can be diversified away earns no premium.
- AThe factor's returns are perfectly predictable, so holding it removes all portfolio risk
- BThe factor performs poorly in bad economic times, so investors must be compensated for bearing that exposureCorrect
- CThe factor is uncorrelated with every other asset, so it earns the risk-free rate plus a fixed spread
- DThe factor is a firm-specific risk that can be diversified, and the market pays a premium for it
Explanation
In factor theory (consistent with the consumption-based asset pricing view), assets earn premiums for bad performance in bad times, when marginal utility is high. Diversifiable idiosyncratic risk earns no premium, and predictable or uncorrelated returns would not command a premium.
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