Skip to content

FRM Part I · FRM Exam Part I · The Arbitrage Pricing Theory and Multifactor Models of Risk and Return

An analyst notes that a stock's return is explained by a two-factor model, but the market portfolio is not one of the factors. The stock's expected return is higher than the CAPM-implied return using its market beta. Which conclusion is most consistent with APT?

Under APT, expected return reflects exposure to all priced systematic factors, not only market beta. So a return above the CAPM value can be fair compensation for other factor exposures. Idiosyncratic risk is diversifiable and is not rewarded, and APT does not need the market as a factor.

  1. AThe stock must be mispriced because CAPM is the only valid pricing model
  2. BAPT is invalid because the market portfolio is not included as a factor
  3. CThe stock's expected return can legitimately differ from the CAPM value if it has exposure to other priced systematic factorsCorrect
  4. DThe difference must be compensation for idiosyncratic risk

Explanation

APT does not require the market portfolio to be a factor. Exposure to other priced systematic factors can justify a return different from CAPM's. Idiosyncratic risk can be diversified away and so is not priced under APT.

Did you get it right without looking?

One question tells you little. A timed set on The Arbitrage Pricing Theory and Multifactor Models of Risk and Return shows your real accuracy, how long you take and where you lose marks.

Practise The Arbitrage Pricing Theory and Multifactor Models of Risk and ReturnFree diagnostic mock

More The Arbitrage Pricing Theory and Multifactor Models of Risk and Return questions