FRM Part II · FRM Exam Part II · Factor Theory
A risk analyst compares two views of a value factor that earns a historical premium. Which description is consistent with a risk-based (rational) explanation rather than a behavioral explanation?
A risk-based explanation says the factor premium compensates investors for suffering losses in bad economic states, such as distress. Extrapolation, overreaction and underreaction are behavioral biases, so they describe a different source of the premium.
- AThe premium exists because investors systematically extrapolate past growth too far
- BThe premium exists because investors overreact to salient news
- CThe premium exists because investors anchor on stale information and underreact
- DThe premium compensates investors for bearing losses in bad states of the world, such as distress periodsCorrect
Explanation
Risk-based explanations attribute factor premiums to compensation for exposure to risk that pays off poorly in bad times. The other options describe investor biases (extrapolation, overreaction, underreaction), which are behavioral explanations.
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