CFA Level I · CFA Level I Exam · The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models
Compared with the capital asset pricing model, a multifactor model used to estimate the cost of equity is most likely to:
A multifactor model captures several sources of systematic risk rather than only market risk, which can improve explanatory power. The trade-off is that more sensitivities and factor premiums must be estimated, increasing the potential for estimation error compared with the single-factor CAPM.
- Arequire only a single market-wide risk premium
- Bcapture several systematic risk sources, at the cost of more estimation errorCorrect
- Celiminate the need to estimate any factor sensitivities
Explanation
Multifactor models add factors such as size or value, so they explain more systematic return variation. They require estimating more sensitivities and premiums, which raises estimation error. The CAPM, not a multifactor model, uses a single market premium.
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