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

Under the Arbitrage Pricing Theory, which risk component is expected to be eliminated through diversification in a well-diversified portfolio containing a large number of securities?

Firm-specific (idiosyncratic) risk is eliminated in a well-diversified portfolio. These error terms are uncorrelated across securities, so they average out as holdings increase, while exposures to common systematic factors remain and are the only risks that earn a risk premium.

  1. AExposure to the factor with the largest risk premium
  2. BFirm-specific (idiosyncratic) riskCorrect
  3. CSystematic risk from the market factor
  4. DExposure to unexpected changes in inflation

Explanation

In APT, each security's return is driven by factor exposures plus an idiosyncratic error term. As the number of holdings grows, the uncorrelated idiosyncratic terms average toward zero. Factor (systematic) exposures remain because they are common across securities and are not diversified away.

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