FRM Part II · FRM Exam Part II · Factor Theory
An analyst models a bond portfolio's excess return using two macroeconomic factors, inflation shocks and growth shocks. The estimated betas are -2.0 to inflation shocks and +0.5 to growth shocks. The factor risk premiums are +0.50% per unit of beta for inflation and +2.00% per unit of beta for growth. Using the model, what is the portfolio's expected excess return?
The expected excess return is 0.00%. The inflation contribution is -2.0 times 0.50%, which equals -1.00%, and the growth contribution is 0.5 times 2.00%, which equals +1.00%. Summing beta times premium across the two factors gives zero.
- A0.00%Correct
- B2.00%
- C-1.00%
- D-2.00%
Explanation
Expected excess return = sum of beta x premium. Inflation: -2.0 x 0.50% = -1.00%. Growth: 0.5 x 2.00% = +1.00%. Total = 0.00%. Using only the growth term gives 1.00%, and the 2.00% option mixes up the betas and premiums.
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