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FRM Part II · FRM Exam Part II · Factor Theory

An investor runs a regression of a fund's excess returns on the market and a value factor and obtains: alpha = 0.50% per year, market beta = 0.90, value beta = 0.40. The market risk premium is 6.0% per year and the value factor premium is 3.0% per year. What is the fund's expected excess return implied by the factor model, excluding alpha, and what is the total including alpha?

The factor-implied expected excess return is 0.90 times 6% plus 0.40 times 3%, which equals 6.60%. Adding the 0.50% alpha gives a total of 7.10%. Omitting the value exposure would understate the factor return at 5.40%.

  1. A6.60% excluding alpha; 7.10% including alphaCorrect
  2. B5.40% excluding alpha; 5.90% including alpha
  3. C6.60% excluding alpha; 6.60% including alpha
  4. D4.20% excluding alpha; 4.70% including alpha

Explanation

Factor-implied return = 0.90×6.0% + 0.40×3.0% = 5.40% + 1.20% = 6.60%. Adding alpha of 0.50% gives 7.10%. Ignoring the value exposure gives 5.40%, which is the key distractor error.

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