FRM Part II · FRM Exam Part II · Factor Theory
A risk manager at a pension fund is reviewing why equities have historically earned a premium over government bonds. Under the factor-based view of asset pricing, which statement best explains the source of the equity risk premium?
Equities earn a premium because they tend to lose value in bad economic times, when investors value wealth most. Investors require compensation for bearing this systematic, non-diversifiable risk. Diversifiable idiosyncratic risk is not rewarded, and zero correlation with the economy would imply no premium.
- AEquities earn a premium because they perform poorly in bad economic times, when marginal utility of wealth is high, so investors demand compensation for bearing that riskCorrect
- BEquities earn a premium because their idiosyncratic volatility is higher than that of bonds, and investors are paid for diversifiable risk
- CEquities earn a premium because their returns are uncorrelated with macroeconomic conditions, which makes them costly to hedge
- DEquities earn a premium because their expected returns are set by the issuer's credit rating rather than by exposure to economic risk
Explanation
In factor theory, risk premiums compensate investors for exposure to systematic risks that pay off badly in bad times, when losses hurt most. Idiosyncratic risk can be diversified away and is not rewarded. Uncorrelated returns would imply no systematic premium.
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