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FRM Part II · FRM Exam Part II · Alpha (and the Low-Risk Anomaly)

An analyst regresses monthly excess returns of a fund on monthly excess market returns and obtains an intercept of 0.20% per month, a slope of 0.80, and a residual volatility of 2% per month. Which interpretation is most consistent with the CAPM framework?

The fund has a market beta of 0.80 and a monthly alpha of 0.20%. The slope measures sensitivity to market excess returns, while the intercept captures average return not explained by that exposure. Residual volatility reflects idiosyncratic risk, not systematic risk.

  1. AThe fund has 0.80 market exposure and earned 0.20% per month of return unexplained by market exposureCorrect
  2. BThe fund has 0.20 market exposure and earned 0.80% per month of return unexplained by market exposure
  3. CThe fund's systematic risk is 2% per month, and its alpha is 0.80
  4. DThe fund's alpha equals 0.20% per month only if the market premium is zero in every month

Explanation

In the regression, the slope is beta (0.80) and the intercept is alpha (0.20% monthly) measured on excess returns. The residual volatility measures idiosyncratic risk, not systematic risk. The swapped interpretation reverses the coefficients.

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